Inventory Management PDF

Inventory Management
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Published by: Amity Directorate of Distance & Online Education, Noida

Contents
Page No.
Unit 1: Introduction to Inventory Management 01

Introduction
Meaning of Inventory
Need of Inventory
Objectives of Inventory Control
Role of Inventory Manager
Inventory and Profitability
Summary
Check Your Progress
Questions and Exercises
Key Terms
Further Readings
Unit 2: Inventory Types and Functionality 15

Introduction
Types of Inventory
Raw Materials
Work in Process Inventory
Finished Good Inventory
Factors Influencing Finished Goods Inventory
Control Measures
Inventory Functionalities
Inventory with Suppliers Including Raw Materials and Other Assets
Summary
Check Your Progress
Key Terms
Further Readings
Unit 3: Selective Inventory Control 33

Introduction
Concept of Selective Inventory Control
Inventory Categorization
Inventory Control through Inventory Classification
Inventory Performance Analysis
Inventory Coding System
Standardisation
Summary
Check Your Progress
Key Terms
Further Readings
Unit 4: Inventory Costs 45

Introduction
Importance of Identifying Inventory Costs
Types of Inventory Cost
Inventory Metrics
ABC (Activity Based Costing)
Summary
Check Your Progress
Key Terms
Further Readings
Unit 5: Inventory Replenishment 61

Introduction
Economic Order Quantity
When to Order
Inventory Models
Functions of Safety Stock
Summary
Check Your Progress
Key Terms
Further Readings
Unit 6: Production Planning and Control 77

Introduction
Concept and Classification of PPC
Scope of PPC
Functions of PPC
Factors Determining PPC
Production Cycle
Measurement of Effectiveness of PPC
Importance of Production-Panning and Control
Organisation Structure of Production Planning and Control Department
Difference between Production Planning and Production Control
Main Elements of Production Planning and Control
Summary
Check Your Progress
Key Terms
Further Readings
Unit 7: Forecasting 90
Introduction
Why Forecast?
Dependent Demands
Independent Demands
Semi-Dependent Demands
Lead Time Management
Considerations in Forecasting
Demand Forecasting Techniques
Causal Relationships using Cause and Effect Models
Summary
Check Your Progress
Key Terms
Further Readings
Unit 8: Materials Requirement Planning 104

Introduction
Overview of MRP System
Purpose of MRP
Requirement of MRP
Materials Planning Process
Bills of Material
Lead Time Determination
Lead Time offset
Aggregation of Demand
Level By Level Exploration
Time Fences
MRP Output
Supplier Scheduling
Summary
Check Your Progress
Questions And Exercises
Key Terms
Further Readings
Unit 9: Spare Parts Inventory 119

Introduction
Definition of Spare Part
Need For Spare Parts Inventory
Classification of Spare Parts
Stocking policies for different classification of spares
Reconditioning and Overhauling Policies
Determination of Optimum Number of Spares – Problems and Solutions
Summary
Check Your Progress
Key Terms
Further Readings
Unit 10: Stores Management 131

Introduction
Controlling Movement of Material
Activities in Warehouse
Warehouse Location and Acquisition
Warehouse Design and Layout
Material Handling and Equipment
Record Keeping
Communications
Quality Standards
Summary
Check Your Progress
Key Terms
Further Readings
Unit 11: Accounting for Inventories 147

Introduction
Accounting for Raw Materials
Work-in-Progress and Finished Goods Stock
Stock Valuation Methods
Accounting for Loss and Pilferage
Summary
Check Your Progress
Key Terms
Further Readings
Unit 12: Just-In-Time 162

Introduction
JIT Basics
Continuous Improvement - Kaizen
JIT Systems
One-piece Flow and Group Layouts
Set-up Costs and Supplier Management
JIT Supply Chain Management
Summary
Check Your Progress
Key Terms
Further Readings
Introduction to Inventory Management 1
Unit 1: Introduction to Inventory Management

Notes
Structure
1.1 Introduction
1.2 Meaning of Inventory
1.2.1 Definition
1.2.2 Advantages of Holding Sizeable Inventory
1.2.3 Disadvantages of Holding Large Inventory
1.2.4 Components of Inventory
1.2.5 Factors Influencing Inventory
1.3 Need of Inventory
1.4 Inventory Management
1.4.1 Objectives of Inventory Management
1.4.2 Problems in Inventory Management
1.5 Objectives of Inventory Control
1.6 Role of Inventory Manager
1.7 Inventory and Profitability
1.8 Summary
1.9 Check Your Progress
1.10 Questions and Exercises
1.11 Key Terms
1.12 Further Readings
Objectives
After studying this unit, you should be able to:
z Understand the concept inventory management
z Discuss the need of inventories
z Explain Inventory Management and its Objectives.
1.1 Introduction
We often keep hearing statements like “Inventory is evil”, “Inventory is a waste”,
“Inventory is an asset”, “Inventory is a double-edged sword”, “Inventory is blocked
working capital”, “Inventory takes care of a rainy day”, etc. These are all so conflicting
and so radically different views of the same stuff – what, then is inventory? What is
inventory management?
The main objective of any business enterprise is “Return on Investment” or what is
normally called ‘Profit’. The profit motive of a company is embedded in all activities of
the company. That is why the concept of ‘Profit Centre’ has evolved, to evaluate the
purpose, performance and contribution of each and every division of the company
towards its common goal. Any amount of money saved on material cost will improve the
bottom line of the company in terms of liquidity, working capital and overall profit of the
company and help withstand the onslaught of competition.
Amity Directorate of Distance and Online Education

2 Inventory Management
In most manufacturing firms today, inventories constitute the second largest

category of assets in the balance sheet, exceeded only by the physical assets like land,
Notes machinery and equipment. Inventories frequently account for more than 30% of the
firms’ invested capital.
Obviously, with so much expenditure on inventories, they have a lot of necessity.
1.2 Meaning of Inventory

The term 'inventory' means any stock of direct or indirect material (raw materials or
finished items or both) stocked in order to meet the expected and unexpected demand
in the future. A basic purpose of supply chain management is to control inventory by
managing the flows of materials. It sets policies and controls to monitor levels of
inventory and determine what levels should be maintained, when stock should be
replenished, and how large orders should be.
Inventory is a stock of materials used to satisfy customer demand or support the
production of goods or services. By convention, inventory generally refers to items that
contribute to or become part of an enterprise's output.
1.2.1 Definition
In simple terms, inventory is an idle resource of an enterprise comprising physical stock
of goods that is kept by an enterprise for future purposes.
In other terms inventory is defined as the blocked working capital of an organisation
in the form of materials. As this is the blocked working capital of the organisation,
theoretically, it should be zero, although it is impossible to do so.
1.2.2 Advantages of Holding Sizeable Inventory

1. They make possible the smooth and efficient operation of a manufacturing concern
by decoupling the individual segments of the total operation. The purchasing
department is able to plan the procurement independently depending on market
conditions, without too much dependence on the shop floor operations.
2. The production department is able to plan daily production with a good amount of
flexibility–unforeseen problems in producing a given component can be mitigated to
a large extent and a different component can be produced at short notice if raw
materials required are in hand.
3. The marketing manager prefers large inventories since it helps him to sell different
products depending on the demand supply situation. The company would be able to
react swiftly to the market forces of demand and release goods in the market ahead
of its competitors.
4. Purchasing managers can place fewer and larger orders, thus reducing the ordering
costs. Larger orders will also often yield volume discounts from suppliers. Large
volume buying also permits more effective utilisation of the buying personnel and
more effective advance planning for major activities such as market studies,
supplier investigations, and so on.
5. Inventories of parts and components produced in-house reduce excessive
interdependence of the various assembly and sub-assembly activities. This enables
the management to effectively utilise the manpower and machinery so that they are
all not tied directly to the final assembly line.
6. Inventories allow suppliers the flexibility to plan, produce and deliver an order for a
given part.
7. Inventories help to decouple the activities in an assembly line. For example, if one
of the processes in an assembly line has broken down or is under repair, this need
not stop the entire assembly line. The rest of the activities can proceed using the
inventories.

Obviously, if inventory had so many advantages, it would have been logical to carry
large inventories by firms. But this is not so. It is a double- edged sword.
Notes
1.2.3 Disadvantages of Holding Large Inventory
1. Inventory masks quality problems. The quality of the finished product depends to a
very large extent on the quality of the raw materials. Suppliers often supply poor
quality and off-spec materials along with their supplies. If this goes unnoticed at the
time of receiving the goods, it is a severe loss since it has been paid for, but at the
same time, it will either not be consumed or remain unnoticed in the inventory, or
else if it is consumed, it will result in substandard finished goods. Either way, it is a
loss because the supplier is able to slip in his poor quality material along with his
regular supply which is a large volume.
2. Inventory hides production inefficiencies. On a given day, if the daily production
plan does not get fulfilled, it does not get much highlighted because of the existing
inventory which does not cause any slippages in the next process. An unfulfilled
daily production plan and high inventory of a particular sub-assembly/assembly
reveals a more dangerous situation – that there is dissimilarity in capacities
between a particular activity and its next activity. Productivity inefficiencies also get
camouflaged due to high inventory.
3. Inventory adds unnecessary costs to the production operation, such as inventory
carrying costs, insurance costs, cost of deterioration/obsolescence, etc.
1.2.4 Components of Inventory

Following are the components of inventory:
1. Raw Materials: Raw material form a major input into the organization. They are
required to carry out production activities uninterruptedly. The quantity of raw
materials required will be determined by the rate of consumption and the time
required for replenishing the supplies. The factors like the availability of raw
materials and government regulations, etc. too affect the stock of raw materials.
2. Work-in-Process or Semi-finished goods: The work-in-process or semi-finished
goods is that stage of stocks which are in between raw materials and finished
goods. The raw materials enter the process of manufacture but they are yet to
attain a final shape of finished goods. The quantum of work-in-process depends
upon the time taken in the manufacturing process. The greater the time taken in
manufacturing, the more will be the amount of work in progress.
3. Consumables: These are the materials which are needed to smoothen the
process of production. These materials do not directly enter production but they act
as catalysts, etc. Consumables may be classified according to there consumption
and criticality. Generally, consumables stores do not create any supply problem and
form a small part of production cost. There may be instances where these materials
may account for much value than the raw materials. The fuel oil may form a
substantial part of cost.
4. Finished Goods: These are the goods which are ready for the consumers. The
stock of finished goods provides a buffer between production and market. The
purpose of maintaining inventory is to ensure proper supply of goods to consumers.
In some organizations the production is undertaken on order basis, in these
concerns there will not be a need for finished goods. The need for finished goods
inventory will be more when production is undertaken in general without waiting for
specific orders.
5. Spares: Spares also form a part of inventory. The Consumption pattern of raw
materials, consumables, finished goods, are from different from that of spares. The
stocking policies of spares are different from industry to industry. Some industries
like transport will require more spares than the other concerns. The costly spare
parts like engines are not discarded after use, rather they are kept in ready position

for further use. All decisions about spares are based on the financial cost of
inventory on such spares and the cost that may arise due to non-availability.
Notes 6. Components: Components are a part or element of a larger whole, specifically a
part of a machine or vehicle. For example electronic components, system
components or a software component. They are the sub-assemblies and play a
major role in functioning of a larger machine or vehicle.
7. Packaging Materials: Any material used for protecting the contents of a product are
termed as packaging materials. It can be wrappers, containers, bags, aluminum
sheets, etc. It will prevent the material from any kind of unanticipated damage such
as pilferage, erosion from dust or mite, loss by fire or accidental mishaps while
dispatching to their destinations.
1.2.5 Factors Influencing Inventory

A truly effective inventory management system will minimize the complexities
involved in planning, executing and controlling a supply chain network which is critical to
business success. The opportunities available by improving a company’s inventory
management can significantly improve bottom line business performance.
From a financial perspective, inventory management is no small matter. Oftentimes,
inventory is the largest asset item on a manufacturer’s or distributor’s balance sheet. As
a result, there is a lot of management emphasis on keeping inventories down so they do
not consume too much cash. The objectives of inventory reduction and minimization are
more easily accomplished with modern inventory management processes that are
working effectively.
Inventory Management Problems
In actual practice the vast majority of manufacturing and distribution companies
suffer from lower customer service, higher costs and excessive inventories than are
necessary. Inventory control problems are usually the result of using poor processes,
practices and antiquated support systems.
The inventory management process is much more complex than the uninitiated
understand. In fact, in many companies the inventory control department is perceived
as little more than a clerical function. When this is the case, the fact is the function is
probably not very effective. The likely result of this approach to inventory management
is lots of material shortages, excessive inventories, high costs and poor customer
service. For example, if a customer orders a product that requires a manufacturer to
acquire 20 part numbers to assemble a product and then, only 19 of the 20 part
numbers are available, you have nineteen part numbers which are excess inventory.
Worse, the product can’t be shipped to create revenue and the customer is not
serviced. Think for a moment about the complexities of making products that require
hundreds and maybe thousands of part numbers to be available in the right quantity, at
the right place and at the right time to make products to satisfy customer orders. It is a
complex network to control and a set of inventory management tasks that must be
performed with precision.
Solutions for Inventory Management Problem
Too much inventory and not high enough customer service is very common, but
unnecessary. There are proven methods that can help you accurately project customer
demand and to calculate the inventory you will need to meet your defined level of
customer service. Using the right techniques for sales forecasting and inventory
management will allow you to monitor changes and respond to alerts when action
needs to be taken. The right approach to inventory management can produce dramatic
benefits in customer service with lower inventory, no matter how complex your network
is. Modern inventory management processes utilize new and more refined techniques
that provide for dynamic optimization of inventories to maximize customer service with
decreased inventory and lower costs. These improved approaches to inventory
management are of major consequence to overall competitiveness where the highest

level of customer service and delivered value can favorably impact market share and
profits.
Notes
1.3 Need of Inventory
Though inventory is an idle resource, it is almost essential to keep some inventory in
order to promote smooth and efficient running of business. To maintain independence
of operations, a supply of materials at a work center allows that center flexibility in
operations.
Consider the case—an enterprise that does not have any inventory. Clearly, as
soon as the enterprise receives a sales order, it will have to order for raw materials to
complete the order. This will keep the customers waiting. It is quite possible that sales
may be lost. The enterprise may also have to pay a high price for various other reasons.
Another aspect relates to the costs for making each new production set up.
Independence of workstations is desirable in intermittent processes and on assembly
lines as well. As the time that it takes to do identical operations varies from one unit to
the next, inventory allows management to reduce the number of setups. This results in
better performance.
Consider the case of seasonal items. Any fluctuation in demand can be met if
possible, by either changing the rate of production or with inventories. However, if the
fluctuation in demand is met by changing the rate of production, one has to take into
account the different costs.
The cost of increasing production and employment level involves employment and
training, additional staff and service activities, added shifts, and overtime costs. On the
other hand, the cost of decreasing production and employment level involves
unemployment compensation costs, other employee costs, staff, clerical and services
activities, and idle time costs. By maintaining inventories, the average output can be
fairly stable. The use of seasonal inventories can often give a better balance of these
costs.
Inventory can be used, among other things, to promote sales by reducing
customer's waiting time, improve work performance by reducing the number of setups,
or protect employment levels by minimizing the cost of changing the rate of production.
Therefore, it is desirable to maintain inventories in order to enhance stability of
production and employment levels.
If the demand for the product is known precisely, it may be possible (though not
necessarily economical) to produce the product to exactly meet the demand. However,
in the real world this does not happen and inventories become essential. Inventories
also permit production planning for smoother flow and lower cost operation through
larger lot-size production. They allow a buffer when delays occur. These delays can be
for a variety of reasons—a normal variation in shipping time, a shortage of material at
the vendor's plant, an unexpected strike in any part of the supply chain, a lost order, a
natural catastrophe like a hurricane or floods, or perhaps a shipment of incorrect or
defective materials.
Broadly speaking, the fundamental needs of inventories are:
z To protect against unpredictable variations (fluctuations) in demand and supply.
z To take advantage of price discounts by bulk purchases.
z To take advantage of batches and longer production run.
z To provide flexibility to allow changes in production plans in view of changes in
demands, etc. and
z To facilitate intermittent production.
Only when considered in the light of all quality, customer service and economic
factors – from the viewpoints of purchasing, manufacturing, sales and finance – does

the whole picture of inventory become clear. No matter what the viewpoint, effective
inventory management is essential to organizational competitiveness.
Notes
1.4 Inventory Management
Having understood what is inventory, let us now go to Inventory Management. Inventory
Management is nothing but efficient management of inventories.
Our home is a perfect example of Inventory Management. We buy several items to
run our homes. Depending on the nature of the item, we buy as much as is required to
meet our daily or weekly or monthly needs. For example, we buy milk on a daily basis,
vegetables on a weekly basis and groceries on a monthly basis. A certain amount of
stock of these items is always maintained; this is called inventory. Before the stock gets
completely over, the next lot is purchased.
Industries do exactly the same thing, only on a larger scale. Only, the numbers of
items are much more and the complexities involved are many. So, organisations have
adopted various concepts and techniques for analysing the inventory issue in order to
arrive at a sound policy for inventory holding by the organisation. This book is devoted
to the study of the various concepts that are currently in use by organisations for
analysing and managing inventories.
1.4.1 Objectives of Inventory Management

Inventory Management must tie together certain objectives, to ensure that there is
continuity between functions. They are:
z Company’s strategic goals
z Sales forecasting or demand management
z Sales and operations Planning
z Production Planning
z Materials Requirement Planning
z Inventory Control
The emphasis on each area will vary depending on the company and how it
operates, and what requirements are placed on it due to market demands. Each of the
above areas will be addressed at length in the succeeding chapters – all these factors
when taken together will help to form a successful program of inventory management.
A good inventory management system provides information to efficiently manage
the flow of materials, effectively utilise people and equipment, coordinate internal
activities and communicate with customers. Inventory Management does not make
decisions or manage operations, but provides information to managers who make more
accurate and timely decisions to manage their operations.
Thus we can say that the inventory management system must be designed to meet
the dictates of market place and support the company’s strategic plan. The changes in
the market demand, new opportunities due to global selling, global sourcing and new
technology means that companies need to align their inventory management systems to
adapt to these changes.
1.4.2 Problems in Inventory Management

Inventory is usually a company’s largest asset. But many companies aren’t satisfied or
are ignorant about the contribution inventory makes towards the overall success of their
business.
Some commonly found problems in Inventory Management are:
1. The wrong quantities of the wrong items are often found in the stores’ shelves.
Even though there may be a lot of surplus inventory and dead stock in their shelves,

stock outs and customer lost sales are common. Material is sometimes not
available at the time and place where it is needed.
2. Computer inventory records are not accurate. Inventory balance information in
Notes
expensive computer systems does not accurately reflect what is available for use in
the stores.
3. The return on investment is not satisfactory. The company’s profits, considering its
substantial investment in inventory, are far less than what could be earned if the
money were invested elsewhere.
Inventory planning occurs at several levels in an organization and covers various
time spans. In the short run it focuses on planning and control of production and MRO
inventories, involving weekly, monthly and in some cases quarterly or yearly decisions.
Longer range activities also take into account sales forecasting, product modification,
aggregate planning and master scheduling.
1.5 Objectives of Inventory Control

India is a country of scarce resources and it is the primary responsibility of each
organisation, whether it is a public or private sector or a government department to
ensure optimum utilisation of resources for production of goods and services. Materials
account for a major portion of this total cost and inventories account for the major part
of the working capital. Therefore, materials management and inventory control playa
critical role in the management of productivity. Supervisors can contribute towards the
optimum utilisation of materials and working capital management through inventory
control. The objectives of inventory control policy are to ensure:
z adequate monitoring and verification of departmental inventories
z efficient acquisition and effective reuse of assets
In other words the objectives are:
1. Maximize customer service
2. Minimize costs
Benefits of inventory management applications:
z complete control of inventory
z complete information about the value of the inventory
z complete visibility on quantities on hand, quantities committed and quantities sold
z response time to demand changes reduced
z Increased sales
z Knowledge of the exact size of merchandizing inventory
z Frequent analysis of purchases, sales and inventory records
z Removal of unnecessary use of warehouse space used by unneeded part of
inventory
z Reduction in excess merchandize stock
z Taxes and insurance premiums paid on excess merchandize inventory avoided
z By providing timely accurate information pertaining to inventory location, movement
and valuation, receipt of goods, sale and return of goods and profits you can make
sure that your inventory is visible throughout a network
The objective of an inventory-control system is to make inventory decisions that
minimize the total cost of inventory, which is distinctly different from minimizing
inventory. It is often more expensive to run out of an item (and thus be forced to obtain
it through more expensive channels) than simply to keep more units in stock. Several
models have been proposed in the literature for minimizing the total cost of inventory
through the use of an economic order quantity, which attempts to balance the carrying
costs of inventory with the cost of running out of an item.
1.6 Role of Inventory Manager

Notes Manufacturing managers face increasing pressure to reduce inventories across the
supply chain. However, in complex supply chains, it is not always obvious where to hold
safety stock to minimize inventory costs and provide a high level of service to the final
customer. In this chapter, we develop a framework for modeling strategic safety stock in
a supply chain that is subject to demand or forecast uncertainty. Key assumptions are
that we can model the supply chain as a network, that each stage in the supply chain
operates with a periodic-review base-stock policy, that demand is bounded, and that
there is a guaranteed service time between every stage and its customers. We develop
an optimization algorithm for the placement of strategic safety stock for supply chains
that can be modeled as spanning trees. Our assumptions allow us to capture the
stochastic nature of the problem and formulate it as a deterministic optimization. How
much inventory do you have? In my travels, the overwhelming answer is “too much.”
Therefore most companies are very interested in finding ways to improve the inventory
process. After all, that is the real objective of JIT— continuous pursuit of improvement.
We believe that success in the continuous pursuit of improvement depends entirely on
good people.
The very people we are depending on to help with continuous improvement are
most often afraid that JIT will cost them their jobs. We must deal with this issue right up
front if we ever expect success. We need to show that people are still going to be the
key to our company’s success. We must work with the human interfaces to our system.
We must enlist the help of all the people and their ideas need to be considered to move
down the road of continuous improvement. We must focus our attention on the people.
The best way to do that is to have a program directed right at training, educating and
motivating our people.
Training is the process of instructing people how to do specific tasks. It is most
often system specific: how to identify locations, what paperwork indicates what actions,
what computer screens input transactions, etc. Most companies understand and fill this
need rather well. Education, on the other hand, is the process of explaining why we do
the things we do. We should explain to our people how their actions impact the next
step in the process and have an effect throughout the logistics pipeline. Explain how
their actions fit into the “big picture” of how our company operates. One of the most
important aspects, however, is motivation. We should include methods to motivate our
people to want to do a good job. People have the need to feel important and a part of
something that is greater than self. Therefore we should have a program to show the
people in our stockroom how important their job really is. Their actions impact the
company very significantly. How well the people work with the inventory process has a
direct effect on our ability to please customers. We need to establish a climate of high
expectations. Every person is a part of the process of delivering quality products to our
customers. Every one of us has the need to be a part of something important. As a
team, our expectations must be set high. “Perfect quality in the stockroom can be our
only acceptable goal,” to quote Darrell Dees of Federal Express. So we have to
constantly be on the lookout for ways to improve the process.
1.7 Inventory and Profitability

In any typical manufacturing firm, more money is spent in purchases of materials
and services than for all other items of expenditure combined, including expenses for
wages, depreciation, taxes and dividends. It can be taken as a benchmark that the cost
of materials is approximately 2½ times the value of all labour and wages and nearly 1½
times the cost of labour plus all other expenses of running a business.
The figure below illustrates the major items of expenditure of a typical
manufacturing organisation. It can be seen that raw materials and stores and spares
together account for 64% of the total expenditure of the firm in a year.

Notes
Figure 1.1: Major items of expenditure of a typical manufacturing organisation

The fact that purchasing is responsible for spending over half of the total outflow of
money in a business highlights the profit-making possibility of the purchasing and
supply function. The figure below illustrates this point.
Labour Sales Net income

850 4700 950
Profit margin
1035 20.21%
22.02%
Cost of goods
Materials sold
1700 3050
Sales
4700
1615 2965
Return on
Overhead Other costs Investment
500 700 4.45%
4.91%
Inventories Current
3930 assets Total assets
7090 Asset turnover
21230 rate
3733
6893 21033 0.221
0.233
A/cs
receivable
1473 Fixed assets Sales
14140 4700
Cash
310
Note: All figures are in Rupees lakhs.

Source: Annual Report of a leading steel mill in India.
Figure 1.2

The various ratios indicated above illustrate the performance of the company.
Notes They have been derived thus:
Net income 950

Profit margin = = = 20.21%
Sales 4700
Sales 4700
Asset Turnover ratio = = = 0.221
Total assets 21230
The top management’s performance is frequently evaluated on the basis of return
they are able to earn on the total capital invested in the business. One common way of
measuring this is to calculate the Return on Investment (ROI) –
net income net income sales

ROI = = × = 20.21 × 0.21 = 4.45%
Total assets Sales total assets
Let us now presume there has been a 5% reduction in material costs. This will
automatically reduce the inventories cost by also 5%, even if there has been no
physical reduction in inventory.
It is seen from the figure above that mere 5% reduction in material costs alone
brings about a saving of ` 85 lakhs. The profit automatically increases by ` 85 lakhs.
If the same profit should be earned by increasing sales, let us calculate the amount
by which sales should increase, assuming that the profit will remain same at 20.21%:
` 1035 lakhs = new sales × 0.2021
New Sales = 1035/0.2021 = 5121.23
This amounts to an increase in sales by ` 421.23 lakhs i.e. by 8.96 %.
Thus, we see from the above illustration that a 5% reduction in material cost alone
would be able to give us a profit equivalent to a 9% increase in sales.
Let us now calculate the various ratios:
Net income 1035

Profit margin = = = 22.02%
Sales 4700
Sales 4700
Asset Turnover ratio = = = 0.223
Total assets 21033
The Return on Investment (ROI) gets improved to–
net income net income sales

ROI = = × = 22.02 × 0.223 = 4.91%
Total assets Sales total assets
A mere 5% decrease in material costs has increased the ROI of the company by
10.33%.
Now are we convinced that the materials management department is a more
effective contributor to the profit of an organisation than anybody else!
1.8 Summary
The main objective of any business enterprise is “Return on Investment” or what is
normally called ‘Profit’. The profit motive of a company is embedded in all activities of
the company. That is why the concept of ‘Profit Centre’ has evolved, to evaluate the
purpose, performance and contribution of each and every division of the company
towards its common goal.

production of goods or services. By convention, inventory generally refers to items that
contribute to or become part of an enterprise's output. Notes
Inventories of parts and components produced in-house reduce excessive
interdependence of the various assembly and sub-assembly activities. This enables the
management to effectively utilise the manpower and machinery so that they are all not
tied directly to the final assembly line.
Inventory adds unnecessary costs to the production operation, such as inventory
carrying costs, insurance costs, cost of deterioration/obsolescence, etc.
Inventory can be used, among other things, to promote sales by reducing
customer's waiting time, improve work performance by reducing the number of setups,
or protect employment levels by minimizing the cost of changing the rate of production.
Therefore, it is desirable to maintain inventories in order to enhance stability of
production and employment levels.
A good inventory management system provides information to efficiently manage
the flow of materials, effectively utilise people and equipment, coordinate internal
activities and communicate with customers. Inventory Management does not make
decisions or manage operations, but provides information to managers who make more
accurate and timely decisions to manage their operations.
Inventory is usually a company’s largest asset. But many companies aren’t satisfied
or are ignorant about the contribution inventory makes towards the overall success of
their business.
The objective of an inventory-control system is to make inventory decisions that
minimize the total cost of inventory, which is distinctly different from minimizing
inventory.
Manufacturing managers face increasing pressure to reduce inventories across the
supply chain. However, in complex supply chains, it is not always obvious where to hold
safety stock to minimize inventory costs and provide a high level of service to the final
customer. In this chapter, we develop a framework for modeling strategic safety stock in
a supply chain that is subject to demand or forecast uncertainty.

Multiple Choice Questions
1. “Inventory is _________ working capital”,
(a) Blocked
(b) Free
(c) Fixed
(d) Temporary
2. Inventory is a stock of materials used to satisfy customer demand or support the
____________ of goods or services
(a) storage
(b) investment
(c) production
(d) marketing
3. Inventories allow suppliers the ___________ to plan, produce and deliver an order
for a given part
(a) flexibility
(b) rigidness

(c) control
(d) learn
Notes
4. The quality of the finished product depends to a very large extent on the quality of
the ______________.
(a) Spares
(b) Work in progress
(c) Raw material
(d) Process
5. Inventory is usually a company’s largest _________.
(A) asset
(b) Liability
(c) Investment
(d) Goods
6. ____________ are the materials which are needed to smoothen the process of
production.
(a) Consumables
(b) Spares
(c) Raw Material
(d) All of the above
7. Inventory control problems are usually the result of using poor __________,
practices and antiquated support systems.
(a) Processes
(b) Principles
(c) Goods
(d) Economy
8. ____________________ and inventory control playa critical role in the
management of productivity.
(a) Cost Accounting
(b) Material Management
(c) Financial Management
(d) Strategic Management
9. Manufacturing managers face increasing pressure to reduce inventories across the
____________.
(a) Company
(b) Industry
(c) Supply Chain
(d) Country
10. Supervisors can contribute towards the ___________ utilisation of materials and
working capital management through inventory control.
(a) Optimum
(b) Less
(C) more
(d) Planned

1. What is Inventory? Is it necessary to have an inventory control system? If so, what Notes
are the benefits from this system?
2. Discuss briefly the advantages and disadvantages of holding inventory in a
manufacturing concern.
3. Discuss the importance and scope of Inventory Management.
4. “Inventories are dead investments”. Comment.
5. What are the factors that an inventory management policy should take into
consideration in a manufacturing concern?
6. “Higher Inventories reduce the profitability of an organization”. Justify.
7. Study the Annual Report of any manufacturing concern. Calculate and find out if the
materials and inventory cost is reduced by 5%, what would be the impact on the
profits of the concern? By what percentage should sales increase for bringing in the
same amount of profit?
8. Discuss the role of inventory manager in inventory management.
1.11 Key Terms

z Inventory: The term 'inventory' means any stock of direct or indirect material (raw
materials or finished items or both) stocked in order to meet an unexpected demand
in the future.
z Finished Goods: Retail is the sale of goods and services from individuals or
businesses to the end -user
z Raw Material: A practice which contributes to the sale of products to a retail
consumer.
z Inventory Management: Retail merchandising is the process by which retail sales
are conducted. It refers to the various activities which contribute to the sale of
products to the consumers for their end use.
z Demand: The number of customers entering a shop or shopping area in a given
time.
z Inventory Cost: Inventory costs are the costs incurred for storing and maintaining
its inventory over a certain period of time.
Check Your Progress: Answers

1. (a) Blocked
2. (c) Production
3. (a) Flexibility
4. (c) Raw Material
5. (a) Asset
6. (a) Consumables
7. (a) Processes
8. (b) Material Management
9. (c) Supply Chain
10. (a) Optimum


Notes z Reji Ismail, Logistics Management, Excel Books, Delhi.
z Narain Prahlad(2008). Inventory Management, Excel Books, New Delhi.
z Kachru Upendra (2007), Production and Operations Management, Excel Books,
New Delhi
z Gopalakrishnan P, Handbook of Materials Management, Prentice Hall of India

Inventory Types and Functionality 15
Unit 2: Inventory Types and Functionality

Notes
Structure
2.1 Introduction
2.2 Types of Inventory
2.3 Raw Materials
2.4 Work in Process Inventory
2.4.1 WIP Computation
2.4.2 Reasons of High WIP
2.4.3 Methods to Control WIP
2.5 Finished Good Inventory
2.5.1 Factors Influencing Finished Goods Inventory
2.5.2 Control Measures
2.6 Inventory Functionalities
2.7 Inventory with Suppliers Including Raw Materials and Other Assets
2.7.1 Advantages of Vendor Managed Inventory
2.8 Summary
2.11 Key Terms
Objectives
z Understand the types of inventory
z Discuss the WIP in detail and its computation
z Explain the concept of inventory with suppliers and its advantages
2.1 Introduction
The inventory constitutes supplies, raw materials, components, in-process goods and
finished goods. The total inventory held is additive in nature. Raw materials and
components are converted to in-process goods and in-process goods are converted to
finished goods. At each stage, the conversion process adds value to the inventory,
increasing the costs associated with holding inventory.
As inventories are necessary and they cost the organisation, inventory decisions
are high-risk and high-impact operations and inventory planning is critical to
manufacturing as well as marketing.
Raw material shortages can shut down a manufacturing line or modify a production
schedule, which, in turn, introduces added expense and potential for finished goods
shortages. Likewise, commitment to a particular inventory assortment, marketing may
find that sales are lost and customer satisfaction will decline. Just as shortages can
disrupt planned marketing and manufacturing operations, overstocked inventories also
create problems. Overstocks increase cost and reduce profitability through added

warehousing, working capital requirements, deterioration, insurance, taxes, and

obsolescence.
Notes
2.2 Types of Inventory
The different types of inventories are given below and each type has different risks
depending upon the firm’s position in the distribution channel:
1. Manufacturing Inventory: Manufacturing inventory is typically classified into raw
materials, finished products, component parts, supplies, and work-in-process.
Independence of workstations is desirable in intermittent processes and on
assembly lines well. As the time that it takes to do identical operations varies from
one unit to the next, inventory allows management to reduce the number of setups.
This results in better performance.
production of goods or services. By convention, inventory generally refers to items
that contributes to or becomes part of an enterprise’s output. There are different
types of inventory. However, the most commonly identified types of inventory are:
1. Raw materials Inventory: Parts and raw materials obtained from suppliers that
are used in the production process. Two important factors that determine the
size of raw material inventory are –
Internal factors: This includes the technology of production, the criticality of the
item and the lead time required for procurement.
External factors: The suppliers’ lead time to manufacture, availability of the raw
materials in the market, seasonality if any, credit situation and government
restrictions.
Organisations, especially those in the FMCG and engineering goods, do not
always produce their output from the raw materials. Some of their components are
bought from other vendors. This enables them to concentrate more on critical parts
and assembling. Many of the companies are going towards this route these days,
including DEIL, GM, and Volkswagen etc
2. Work-in-process (WIP) Inventory: This constitutes partly-finished parts,
components, sub-assemblies or modules that have been started into the production
process but not yet finished. They comprise of the semi-finished products formed at
various stages of the production process. Typically, the output of one stage in an
assembly line is the input for the next stage
3. Finished goods Inventory: Finished product or end-items. This comprises of
all the final products made by the company, ready for shipment and sale. The
purpose of this inventory is to assure a constant supply to the distribution
channels.
4. Replacement Parts Inventory: Maintenance parts meant to replace other parts
in machinery or equipment, either the company’s own or that of its customers.
5. Supplies Inventory: Parts or materials used to support the production process,
but not usually a component of the product.
6. Transportation (pipeline) Inventory: Items that are in the distribution system
but are in the process of being shipped from suppliers or to customers.
7. Consumables: These are the materials which act as ‘Catalyst’ in the production
process and do not enter into the end product or out put. Some examples are
solvents, compressed gases, grinding wheels, abrasives, cutting oils, coolants, etc.
These enable the
production process to function smoothly. The inventory level of these consumables
can be fixed based on the past consumption. Normally these items do not create
any supply problems, as they are widely used in many industries and readily
available from multiple suppliers.

Though the description above focuses on manufacturing inventory, wholesalers and
retailers have corresponding inventory types.
Notes
In the case of seasonal items, any fluctuation in demand can be met if possible, by
either changing the rate of production or with inventories. However, if the fluctuation in
demand is met by changing the rate of production, one has to take into account the
different costs. The cost of increasing production and employment level involves
employment and training; additional staff and service activities; added shifts; and
overtime costs. On the other hand, the cost of decreasing production and employment
level involves unemployment compensation costs; other employee costs; staff, clerical
and services activities; and idle time costs. By maintaining inventories, the average
output can be fairly stable. The use of seasonal inventories can often give a better
balance of these costs.
In addition, the firm also has to have in-services inventory. This generally refers to
finished goods, the tangible goods that must often be transferred to warehouses in
close proximity to wholesalers and retailers to be sold, and the supplies necessary to
administer the service.
2. Wholesale: The wholesaler purchases large quantities from manufacturers and sells
small quantities to retailers. He provides the capability to provide retail customers
with assorted merchandise from different manufacturers in smaller quantities.
Expansion of product lines has increased the width and inventory risk. Where
products are seasonal, the wholesaler has to take an inventory position far in
advance of selling.
3. Retail: For a retailer, inventory management is fundamentally a matter of buying and
selling. The retailer purchases a wide variety of products and markets them. The
prime emphasis in retailing is on inventory turnover and direct product profitability.
Turnover measures inventory velocity and is calculated as the ratio of annual sales
divided by average inventory.
4. MRO Inventory: This stands for Maintenance, Repair and Operating supplies.
These items are very much required in the production process although they do not
go into making the final product. They include –
a) Consumables which are usually available off the shelf and are used by more
than one usage departments. Their inventory levels are fixed based on past
consumption. They include lubricating oils, safety items, electrical items such as
lights, fans etc.
b) Spare parts, which are the parts of machines which are used in the production
process. They are a class by themselves.
c) Packing material: They are used to give a facelift to the product, to protect it
during transportation and storage. In the pharmaceutical industry, packing cost
is substantial and is usually given the same treatment as raw materials. In some
cases, packing materials are a part of consumables, especially in cases where
the finished product is in a liquid form such as juices, syrups etc.
5. Balance Sheet Inventory: For financial reporting purposes, inventories are treated
as part of the working capital in the Balance Sheet and are classified thus –
a) Goods in Transit (GIT) or Stores in Transit (SIT): This includes all materials
which have already been paid for but not yet received in the stores and
accounted for.
b) Stores: It includes all materials physically held at the store, which has been
accounted for.
c) Work in Process (WIP): Materials issued to the shop floor which have not yet
become finished goods; these are value added materials to the extent of labour
costs incurred.
d) Stock in Trade (SIT): These include all finished goods, ready for sale.

Not all types of inventories are held by all businesses. Retail service organizations
hold only supplies. Retail sales organisations, wholesalers and distributors hold both
Notes supplies and finished products. Projects and intermittent processes in manufacturing
hold supplies, raw materials and in-process inventory. However, most continuous
manufacturing organisations hold all the different types of inventory.
Some of the types of inventory are discussed in detail hereafter.
2.3 Raw Materials

Raw materials are those items purchased to be processed and are major inputs into an
organisation and form the bulk which gets converted into output. The function of raw
materials inventory is to act as a buffer between procurement and manufacturing. They
may be steels, ferrous alloys, aluminum and other non-ferrous alloys, ores, timber,
cotton, chemicals, etc. to be stored for manufacturing into finished goods.
There are two important factors (internal and external to determine size of raw materials
inventory.
(a) Internal Factors
Production Technology
Criticality of the item
Administrative Lead Time
The raw materials inventory needs tighter control where the consumption or
criticality is higher.
(b) External Factors
Supplier’s Lead Time
Vendor Relations: Good relations with suppliers usually have great influence on
prompt supplies. This is a matter not usually realised, which has a major
influence in management of raw materials inventory
Availability of raw materials in the market
Government Policy: Especially in regard to imports and more so in case of
canalised items’ import
Seasonality
Credit situation and Governmental Restrictions
Depending upon internal and external factors the levels of inventory will have to be
fixed.
2.4 Work in Process Inventory

Work in Process inventory consists of materials in various stages of semi-fabrication or
manufacture or assembly. They comprise of the semi-finished products formed at
various stages of the production process. Typically, the output of one stage in an
assembly line is the input for the next stage.
Obviously, WIP is a substantial portion of a company’s assets. Many companies,
such as car manufacturers, prefer to keep in stock the bare cars without any fittings, in
their inventory. Then, as per the customers requirements, the fittings such as heaters,
tyres, etc. are fitted and the cars sold. So obviously, they prefer to maintain WIP rather
than finished goods inventory, since they cannot stock all the various combinations of
their fittings.
But it is not so easy in other situations. Besides blocking scarce working capital,
WIP would also incur:
z Storage space required to keep the inventory and consequent storage costs
z Inventory carrying costs for such materials
z Handling costs involved in shifting the material from the assembly line to the
storage point and again from the storage point to the next process. This expense is
nothing but a waste. Notes
z Lost opportunity costs: If instead of lying on the factory floor, the material could be
converted speedily into the finished product, it could be sold in the market and cash
flow would be faster. It would result in more profits for the organisation.
The amount of WIP required would depend on the process. The requirement of WIP
inventory in the five basic process types as follows:
a. Job-shop: Job-shop is used when a low volume and a large variety of goods or
services are needed. Job-shop involves intermittent processing, high flexibility,
skilled workers, relatively large work-in-process inventories and general-
purpose machinery. An example is a tool and die shop that is able to produce a
wide variety of tools.
b. Batch: Batch processing is used when a moderate volume of goods and services is
demanded. It is designed to handle a moderate variety of products. The processing
is intermittent. The flexibility of the process to produce a variety of goods, the skill of
the workers, amount of work-in-process inventories are all less than in job
shop. A typical example of batch processing is paint manufacturing.
c. Repetitive: This type of a process involves higher volumes of more standardized
goods or services. The flexibility of the process to produce a variety of goods, the
skill of the workers, amount of work-in-process inventories are all less than in
batch process. Typical examples for this type of process include appliances and
automobiles.
d. Continuous: This type of a process involves very high volume of highly
standardized goods or services. These systems have no flexibility in output or
equipment. Workers are generally low-skilled and there is no work-in-process
inventory. The machines are dedicated to perform specified tasks. Typical
examples include petroleum products, steel and sugar manufacturing.
e. Project: Projects are designed to be used with non-routine, unusual tasks or
activities. These activities are generally not repeated. Equipment flexibility, level of
worker skills and work-in-process inventory can range from very low to very
high. Examples include construction of a dam or a bridge, installing and
implementing a new bar coding system.
2.4.1 WIP Computation

Work in Process Inventory can be computed as follows:
Cost to manufacture (at a particular location or job) = Direct Materials used + Direct
labour + Manufacturing overhead
Cost of goods manufactured = Cost to manufacture + beginning WIP – ending WIP
* It should be remembered that materials manufactured at each location constitute
the work in process inventory of that location. It is the finished product of that location.
This becomes the raw material for the next process.
Just like any other form of inventory, maintaining a work in process inventory means
money blocked, which could have been used for other more productive purposes. If
unnoticed, this has the potential to seriously hamper the profitability of the firm. But at
the same time, it is impossible to maintain a zero WIP. What then is the correct WIP
that an organisation must maintain? As usual, there is no formula that can be applied,
but there can be several methods that could help to maintain WIP at optimum levels. To
begin a study of the methods that can be used to optimize WIP, let us first look at the
reasons for high WIP.

2.4.2 Reasons of High WIP
Notes The factors that cause high WIP are:

1. Imbalances in machine times at different stages of production: Most of the
times, the various processes in a production system do not run in sync. Process-2
may not be ready to accept the material that has been produced by Process-1 and
it could be lying on the shop floor. This results in WIP. This is the single most
common reason for high WIP.
2. Faulty Planning: WIP can also result due to faulty production planning, where the
capacities of all the processes are not considered properly. If the capacity of
Process-2 is higher than Process-1, then there could be idle machine time, wherein
the machine could be idle due to want of material from Process-1. But if capacity of
Process-2 is lesser than Process-1, then the output of Process-1 would keep piling
up and result in a huge WIP. Both the situations are dangerous for an organisation.
WIP can also arise if it is decided to stop the production of an item midway and
begin the production of some other, more urgent item.
It can also happen that machine performance would decline as it ages and several
processes would need to be reworked or repeated. This would cause imbalance in
the sequenced processes and result in build up of WIP.
3. Stage Inspection: The manufacture of certain products might require stage
inspection by the buyers. In such cases, after certain stages, the buyer who
conducts the inspection is called. The material would be lying as WIP till it is cleared
for further processing by the buyer.
There can be several other reasons. What should be kept in mind is that WIP is an
expensive waste and should be controlled. WIP is all the more dangerous because
it is not as obvious as raw materials or finished goods inventories and one cannot
easily find out which of the inventories are unnecessary or avoidable.
A firm that has efficient internal operations will have low WIP. In American
companies, between 1981 and 2000, WIP decreased by about 6% every year.
2.4.3 Methods to Control WIP

1. The first step would be to prepare a process flow chart that would list each and
every activity and trace the material from start to finish. This chart should reveal
where each material goes, how long it takes there, what is the idle time, etc. Such
charts are best prepared by the Industrial Engineering/Operations Research Group.
From the chart, it should be possible to identify delays and analyze and categorise
them as warranted. This step should be carried out with utmost care and honesty
since the entire exercise of control would depend on it.
PERT/CPM diagrams are also sometimes drawn to reveal the production cycle, at
what stages, various items and components enter into the production process, time
taken at each process etc. Any deviations from these diagrams then reveal the
wastes.
2. Bill of Materials (BOM) should be drawn properly and informed to Procurement
division well in advance. As we all know, the Bill of Materials indicates when each
material is required and how much is required in the production process. When
slippages occur and materials are not available, the production of the subsequent
stages might get postponed. In all such instances there should be proper
communication between the various departments concerned. If such
communication is insufficient or absent, higher WIP can result.
3. The Production Planning and Control Group (PPC) is generally given the
responsibility of controlling WIP inventories. This group should be in a position to
assess the inventory levels of the WIP stocks based on planning and production
details.
4. Fixing of norms and targets for holding WIP should be made compulsory.

5. An effective MIS should be developed wherein the status of WIP inventories should
be reported. These reports should also include reasons for increase in WIP and
steps taken to control the same. An age-wise analysis can be carried out which Notes
would help identify non-moving or stagnant work orders; they can be analysed and
closed wherever appropriate.
6. Sometimes special teams are formed to study the WIP and suggest ways and
means to control them. These teams are usually cross-functional, with members
drawn from production, materials, industrial engineering, accounts and other service
departments.
This is by no means exhaustive. Depending on the nature of the organisation and
their environmental compulsions, companies have to formulate their own formulae
to optimize and maintain the Work In Process Inventory.
2.5 Finished Good Inventory

Finished goods are the completed products waiting for sale.
The cost of inventory consists of all the costs involved in buying and preparing
merchandise for sale. The cost of finished goods inventory is the total of the materials,
labour, and manufacturing overhead costs used in the production process for those
items. In business, inventory is often used synonymously with “finished goods” or
products that are being stored until it is sold or consumed. Having too much inventory is
a liability for any business, as it represents an investment that has not paid off, and if
the inventory proves to be unsalable, the inventory will eventually have to be destroyed.
Businesses always have to evaluate the ongoing cost of storing their inventory,
balanced against the probability that they will be able to sell it eventually at a profit. If
the ongoing storage cost is higher, then the inventory should probably be destroyed.
On the other hand, if the business stocks too little inventory, it may not be able to
take advantage of some sales opportunities, if large orders were to be placed by its
customers and the company were to find it unable to satisfy its customers.
Thus, we can conclude that no company can afford to have a “NIL” finished goods
inventory since there is virtually no product which has a zero product cycle time (barring
certain fast food items such as pizzas, burgers, dosas etc.). However, this does not
mean that inventory can assume any size since it costs the company quite a lot to hold
a finished goods inventory of any size. Companies would like to keep an optimum size
of this inventory consistent with the targeted service level to their customers. In other
words, even this very useful instant revenue earning inventory needs to be carefully
controlled and one needs to understand the factors influencing this inventory and the
control measures that would be effective and appropriate.
2.5.1 Factors Influencing Finished Goods Inventory

There are several contributory factors to finished goods inventory. Let us begin our
study by learning the various factors:
1. Forecasting demand: We know that all manufacturing activities begin with a
forecast of the demand. If demand forecasts are not accurate, it will result in either
a large inventory due to lower sales or result in lost sales even if there is very low
inventory.
2. Seasonality: The market demand for certain products varies with the seasons. For
example, demand for clothes increases during the Puja/Diwali festivals by almost
50% of the annual sales. Demand for woolens during winters is almost 90% of the
annual sales, demand for air conditioners and air coolers is again 90% of the
annual sales during summers and so on.
3. Unpredictable demand: Sometimes, finished goods inventory will have to be
maintained to take care of unpredictable and unforeseen demand. This is more
common in case of medicines and related equipments – in the recent Mumbai
floods and the outbreak of epidemic thereafter; there was a sudden and huge
demand for antibiotics. Stocks need to be maintained to meet such unpredicted

demands.
Notes 4. Technological factors: Sometimes there are some peculiar situations which compel
companies to stock certain items. Take for example, huge machinery manufacturing
companies such as Mannesman Demag of Germany. Their offices in India would
have sold machinery to Indian companies. They may also feel that they should
stock spares of the machineries they have sold, in order to retain the goodwill of the
customers, who may want the spares three, five or ten years hence. One can find
hundreds of such items in warehouses, moving slowly if at all, occupying
tremendous storage space, sometimes deteriorating due to long or unsatisfactory
storage conditions. One reason for such stocking is that spares are not available
after a few years because the manufacturer has changed the model and old spares
are not manufactured. For this reason, a company imports a large number of spares
along with the original equipment.
5. Economic Batch Production: Sometimes the economic batch production quantity
may not match with the sales. This could lead to build up of inventory. For example,
a rolling mill chalks out a rolling program for various sizes and each rolling schedule
lasts for a month. If the quantity rolled in a particular schedule is more than the
sales predicted till the next rolling schedule, there will be a build up of inventory.
6. Multiple stock points: A company may have several stock points or storage
destinations across the country. If each of these depots store the entire product
range of the company’s products, imagine the amount of inventory a company holds
at any point of time! Take the case of a large steel conglomerate such as SAIL –
SAIL has seven steel plants besides a huge network of six regional offices, 42
stockyards and so on!
7. Logistics: Goods in transit contribute considerably to total finished goods inventory.
This is especially true in case of sea and rail transport, where we find that goods
equivalent to almost a month’s sale are in transit all the time.
8. Nature of inputs: Companies depending on imports for some of their inputs find
themselves saddled with a larger inventory at all times. Imported goods are unique
in the sense that they generally have a very high lead time compared to normal
procurements. This necessitates holding a larger inventory than that derived from
normal inventory calculations. Also, the uncertainties are much higher.
Governments may impose restrictions and controls-delays in transportation are
more probable. Companies producing the products involving imports manufacture
the goods much ahead of the actual market demand. This results in excessive stock
of the finished goods inventories.
A well-calculated strategic decision is called for while controlling such factors in the
overall management of inventories.
Every inventory control measure starts with a focus on costs. Traditionally, the
entire marketing department has always focused on profit margins and completely
ignored the cost of carrying finished goods inventory. But with the present era of
cut-throat competition, companies have begun to look at all the areas that can bring
in cost reduction.
2.5.2 Control Measures

Several control measures can be undertaken that will help in keeping finished goods
inventory under control. A few are explained below:
1. MIS: Companies can begin by presenting to the top management every month,
quarter and year, a statement showing the amount of finished goods inventory and
the inventory carrying costs on finished goods. This statement is bound to create
the necessary consciousness in this matter.
2. Proper Demand Forecasting: The importance of demand forecasting in regard to
control cannot be more exaggerated. This is the crux of the whole problem. If

forecasts are done by the rule of thumb method without proper market research,
careful analysis and thought, their effect can be seen and felt in warehouse stocks.
Since finished goods inventory arises due to errors in sales forecasting, one Notes
strategy is to improve forecast accuracy by spending more time, effort and money in
the annual forecast. Several computerized models are available, which can take
care of random fluctuations, seasonality and trend.
3. Fixing of norms: Several norms or benchmarks can be fixed for several
parameters. For example, the inventory can be expressed in terms of number of
months’ sale. Maximum and minimum levels can be fixed for each item separately
and not for the entire lot of finished goods as a whole. These levels should depend
on the size and frequency of replenishment and the service level desired.
4. Determination of contingency stocks: As we have read earlier in this chapter,
there can be sudden spurts of demand that were not predicted. This can occur with
only some of the products of a company and not all the products. These have to be
isolated and using past data as a guide, a contingency has to be anticipated on a
very short-term basis. The quantum of contingency stock to be carried will depend
upon experience and a policy decision to be taken by the top management of the
company after fully considering the probability of occurrence of the increased
demand and the financial implications of carrying the higher inventory.
5. Economic Batch Production: It might not always be wise to keep the concept of
economic batch production as sacrosanct. Where there are problems of economic
batch production, the standard stock should be fixed keeping this requirement in
mind, in addition to the forecasts and past sales. A systems view needs to be taken
and it is necessary to optimize the total costs rather than consider each cost in
isolation. The extra cost involved in producing an economic batch should be
compared with the inventory carrying cost and a decision should then be taken
whether to stick to the economic batch and carry inventories or reduce the size of
the economic batch and lower inventory carrying costs.
6. Stock of Obsolete parts: As we have seen earlier, sometimes due to technological
considerations, it becomes necessary to stock certain spares. Sometimes, it can
also be called a tendency of the Sales Department to exaggerate the significance of
this matter and not want to lose customer goodwill on this score. In today’s context
of fast changing technology, such a traditional approach can lead to disastrous
results. There is a limit to which a company should go and this limit should be
decided by the top management.
When a model gets changed, it is best to inform all the old customers about it and
ask them what spares they may require. Customers should be informed that they
are unlikely to obtain the spares later. Instead of keeping spares, it may be better to
keep drawings. Goodwill of customers need not be lost if the responsibility of
keeping spares is given to them and they are given suitable advice as to what
spares they need to carry. All this requires a broader approach to achieve the
desired results.
7. Logistics: Transit time taken for the finished goods is often substantial. This should
be reduced by several means. A good example of how this was done is the oil
sector in India. Till a few years back, petroleum products were moved in wagons –
the wagons would be loaded at the refinery terminal siding and from there they
would be sent to the marshalling yard of the railways. They would remain there for
any number of days till they were attached to the train going to the destination
which the wagon was meant for. It was found that the wagons remained in the
marshalling yard for any number of days ranging from 30 to 45 days.
The oil sector entered into an arrangement with the railways and it was decided that
only rake loads could be moved henceforth. A rake loaded at the refinery siding was
meant for only one destination. This way the transit time was reduced from 30 days to
7-10 days. The money spent in increasing the storage capacity at the receiving point
was much less compared to the money saved in idle inventory and freight due to
movement in wagon loads.

2.6 Inventory Functionalities

Notes The ideal inventory process consists of manufacturing a product to a customer's
specifications once an order is placed. This is called a make-to-order operation and is
characteristic of customized equipment. Such a system does not require stockpiles of
materials or finished goods in anticipation of future sales.
z Geographical Specialization: One function of inventory is to allow geographical
specialization for individual operating units. Because of the requirements for factors
of production such as power, materials, water, and labor, the economical location
for manufacturing is often a considerable distance from major markets. For
example, tires, batteries, transmissions, and springs are significant components in
automobile assembly. The technology and expertise to produce each of these
components are traditionally located in proximity to material sources in order to
minimize transportation. This strategy leads to geographical separation of
production so that each automobile component can be produced economically.
However, geographical separation requires internal inventory transfer to completely
integrate components into final assembly.
Geographical separation also requires inventories to create market assortments.
Manufactured goods from various locations are collected at a single warehouse and
then combined as a mixed-product shipment.
Geographical separation permits economic specialization between the
manufacturing and distribution units of an enterprise. When geographical
specialization is utilized, inventory in the form of materials, semi finished goods or
components, and finished goods is introduced to the logistical system. Each
location requires a basic inventory. In addition, in-transit inventories are necessary
to link manufacturing and distribution. Although difficult to measure, the economies
gained through geographical specialization are expected to more than offset
increased inventory and transportation cost.
z Decoupling: A second inventory function, decoupling, provides maximum operating
efficiency within a single manufacturing facility by stockpiling work-in process
between production operations. Decoupling processes permit each product to be
manufactured and distributed in economical lot sizes that are greater than market
demands. Warehouse inventory produced in advance of need permits distribution to
customers in large quantity shipments with minimum freight cost. In terms of
marketing, decoupling permits products manufactured over time to be sold as an
assortment. Thus decoupling tends to "buffer," or cushion, the operations of the
enterprise from uncertainty.
Decoupling differs from geographical specialization: the former enables increased
operating efficiency at a single location, while the latter includes multiple locations.
z Balancing Supply and Demand: A third inventory function, balancing, is concerned
with elapsed time between consumption and manufacturing. Balancing inventory
reconciles supply availability with demand. The most notable examples of balancing
are seasonal production and year-round consumption. Orange juice is one such
product. Another example of year-round production with seasonal consumption is
antifreeze. Balancing inventories link the economies of manufacturing with
variations of consumption.
z Buffer Uncertainties: The safety stock or buffer stock function concerns short-range
variation in either demand or replenishment. Considerable inventory planning is
devoted to determining the size of safety stocks. In fact, most overstocks are the
result of improper planning.
The safety stock requirement results from uncertainty concerning future sales and
inventory replenishment. If uncertainty exists, it is necessary to protect inventory
position. In a sense, safety stock planning is similar to purchasing insurance.
Safety stock protects against two types of uncertainty. The first type concerns
demand in excess of forecast during the performance cycle. The second type of
uncertainty involves delays in the performance-cycle length itself. An example of

demand uncertainty is a customer request of more or less units than planned.
Performance-cycle length uncertainty results from a delay in order receipt, order
processing, or transportation. Notes
Thus we can say that or rather we can conclude that:
1. The four functions of inventory are geographical specialization, decoupling,
balancing supply and demand, and buffering uncertainties with safety stock.
2. Inventory policy consists of guidelines concerning what to purchase or manufacture,
when to take action, and in what quantity. It also includes decisions regarding
inventory positioning and placement at plants and distribution centers. For example,
some firms may decide to postpone inventory positioning by maintaining stock at
the plant.
3. The second inventory policy element concerns inventory management strategy.
4. Service Level: The service level is a target specified by management. It defines the
performance objectives that the inventory function must be capable of achieving.
5. The service level can be defined in terms of an order cycle time, case fill rate, line
fill rate, order fill rate, or any combination of the above.
6. The performance cycle is the elapsed time between the release of a purchase order
by a customer and the receipt of the corresponding shipment.
7. The performance cycle is the elapsed time between the release of a purchase order
by a customer and the receipt of the corresponding shipment.
8. Average inventories include cycle, safety stock, and transit inventory components.
9. Cycle Inventory Cycle inventory, or base stock, is the portion of average inventory
that results from the replenishment process. At the beginning of a performance
cycle, stock is at a maximum level. Daily customer demands "draw off" inventory
until the stock level reaches zero.
10. A replenishment order is initiated so that stock will arrive before a stock out occurs.
The replenishment order must be initiated when the available inventory is greater
than or equal to the customer demand during the performance-cycle time. The
amount ordered for replenishment is called the order quantity.
11. The average inventory held as a result of the order process is referred to as base
stock.
12. Another commonly used term to identify this aspect of inventory is lot size stock.
13. Transit Inventory represents stock that is either moving or awaiting movement in
transportation vehicles. This portion of total inventory is referred to as transit or
pipeline inventory.
14. From a logistics management perspective, transit inventory introduces two sources
of complexity into the supply chain. First, transit inventory represents real assets
and must be paid for, even though it is not accessible or usable. Second, there has
typically been a high degree of uncertainty associated with transit inventory
because shippers were unable to determine where a transport vehicle was located
or when it was likely to arrive.
15. Safety Stock Inventory: The second part of average inventory is the stock held to
protect against the impact of uncertainty on each facility. This portion of inventory is
called safety stock. Safety stock inventory is used only at the end of replenishment
cycles when uncertainty has caused higher than expected demand or longer than
expected performance-cycle times.
2.7 Inventory with Suppliers Including Raw Materials and Other

Assets
Traditional thinking made organisations stock their requirement of inputs at their own
premises to ensure ready availability when required and this led to the concept of
inventory. The advent of Just In Time inventory concept and supply chain management
have opened up fresh possibilities of ensuring ready availability of materials without

oneself holding inventories of these materials. Raw materials and components of the
Notes correct quality, spare parts, consumables, etc. lend themselves to being held by the
suppliers themselves in readiness to be supplied instantly/at short notice. Some
examples are automobile tyres, feed stock in chemical industry, machinery spares etc.
Instead of an organisation holding an inventory of such materials, one could have a long
term contract with the supplier to make them available on a day to day or even hour to
hour basis, in a guaranteed and assured manner. All that would be necessary is to treat
the supplier as an extension of the organisation and let him have access to one’s own
production schedules and medium/long term plans. This would amount to a Stock-less
Production situation and is the most sought after system today. Of course, there will be
a small element of additional cost since the supplier will have to hold some inventory,
which he would not otherwise have to hold. If this cost is less than one’s own inventory
carrying cost it will certainly be financially feasible and advisable, and saves a lot of
non-financial effort on one’s own part.
A modified version of the same concept is the holding of materials of the supplier on
Consignment Basis. The supplier maintains his stocks at your premises, at his own cost
and you can draw them as and when required and you pay for only what you actually
draw, when you draw them. This is quite common in the Pharmaceutical Industry where
retail chemists hold medicines which are paid for only after the chemist sells them.
A little thought will tell us that leasing a machine or plant is an extension of the
same concept. An Annual Maintenance Contract (AMC) with the contractor’s engineer
stationed at your premises is also an extension of the same concept.
We have learnt that all organisations carry inventory in order to cater to their needs
of production and also act as a buffer against fluctuating demand and delays in
deliveries. But obviously, organisations cannot stock huge quantities of all the items
they use. Take the simple case of hospitals. They need to have easy access to all kinds
of patient care materials and medicines at all times. Loss of life cannot be risked
because of unforeseen circumstances such as strikes, delays, natural calamities, etc.
However, this does not also mean that the hospitals should stock all the required
materials in their storerooms. This is neither possible nor desirable. Instead, the
hospitals prepare a list of all the materials they need to keep in stock along with the
quantities, and direct the supplier to maintain the stock with them and also to earmark
them solely for the hospital. This clause can also be incorporated as a legal requirement
in the purchase contract. Such an inventory is called Vendor Managed Inventory (VMI)
or Supplier Managed Inventory (SMI). The supplier can own and manage the inventory
at their premises or at the buyer's premises. The buyers pay for the items as and when
they draw them for their use from the suppliers' premises.
The supplier's stores system literally becomes an extension of the buyer's stores
system. This concept helps the buyer to achieve protection against any stock-outs at
much lower warehousing costs than by using his own storerooms.
We can now define Vendor Managed Inventory or VMI as “A means of optimising
supply chain performance in which the manufacturer or seller is responsible for
maintaining the distributors/end user’s/buyer’s inventory levels. The manufacturer/seller
has access to the distributors/end user's/buyer’s inventory data and is responsible for
the same.”
Thus, VMI reduces stock outs and optimizes inventory in the supply chain. The
salient features of VMI include:
z Shortening of supply chain
z Centralized forecasting
z Frequent communication of inventory, stock outs and planned promotions
z Trucks are filled in a prioritized order e.g. Items that are expected to stock-out have
greater priority than items that are just below targeted stock levels or advance
shipments of promotional items.
Most progressive companies have changed their procurement concept from 'when'
and ‘how many to order’ to ‘when’ and ‘how many to deliver’. One good example of
vendor managed inventory can be seen in the consignment stocking points of Indian Oil Notes
Corporation. They have established consignment stocking points inside the SAIL steel
plants where they stock furnace oil, diesel, etc. As and when the steel plant draws their
stock, IOC gets paid for the quantity that is drawn by SAIL. It is IOC's responsibility to
replenish their stock depending on the utilisation rate by SAIL.
Another good example is Wal Mart, a chain of retailer stores across the US.
Whenever a customer purchases an item from Wal Mart, the item's bar code is scanned
at the customer checkout point. The data is transmitted not only for payment purposes,
but is also sent to a centralised information processing location where such sales for
every item are aggregated and the information sent to the appropriate supplier who then
replenishes their stock at the Wal Mart shelves.
Janice Burk, who leads the Vendor Managed Inventory (VMI) team for Rockwell
Automation is on record stating that they have recently embarked on an effort to
increase the percentage of their domestic business handled by VMI from 20% to 70%.
2.7.1 Advantages of Vendor Managed Inventory

The advantages of a vendor managed inventory are:
1. Vendor managed inventory results in dramatic inventory reductions across the
supply chain as there is only one inventory control point. Complete supply chain
inventory visibility allows for the reduction of redundant safety stocks at different
supply chain points.
2. Sales often increase because the vendors are better informed about which products
the consumers are buying; so they have a much smaller range of products to keep
in the market.
3. Increasing the customer's profitability on their product line makes the supplier's
product less expensive to carry when compared to the supplier's competitors.
Moving to a preferred provider level is the number one reason a supplier does VMI.
4. Increasing the customer's profitability helps ensure the long-term survival of the
customer. Good customers are hard to find. It is good business to ensure the ones
that you have survive.
5. A more thorough understanding gained through VMI helps the supplier make better,
fact-based decisions across a wide range of topics such as production planning,
package quantities, promotion plans and new product introduction.
This concept is very prevalent in the case of internet stores such as Amazon.com
etc. who cannot obviously stock all the items available on their catalogue. A similar
Internet site, CircuitCity.com practices this principle to sell compact discs, videos and
DVDs to their online offerings of consumer electronics and avoid taking on huge
inventories. To add movies alone, they were looking at carrying upwards of 55,000
video and DVD titles if their online selection was to meet the Web shopper's
expectations - compare this with the 300 to 500 titles available in any standard video
library. Experience also showed that Web customers tend to go a lot more for the
classic titles, not necessarily the latest releases or hits, so to serve the online
customers, the range had to be exhaustive.
The concept of "Online Category Manager" has been adopted by Circuit City. The
Category Managers own the product inventory. Circuit City does not buy any movie or
music titles from its online Category Manager until an online sale is made at Circuit
City.com. Circuit City then pays its Manager and makes its profit from the higher price it
charges from its Web customer. This arrangement is beneficial to both — the managers
need to stock only their category of titles and do not incur any expenditure on this
additional sales; Circuit City is also saved of the botheration of maintaining inventory
and does what it does best — that is electronic commerce.

With VMI, the customer doesn't give up all responsibility for inventory management.
Before beginning a VMI relationship, the customers must make it very clear what their
Notes expectations are for inventory turns and fill rates. As the relationship progresses, the
customer must check to make sure the objectives are achieved. If the supplier is taking
advantage of the relationship, then the customer is not receiving the benefits of VMI and
should discontinue VMI with that supplier.
2.8 Summary
The total inventory held is additive in nature. Raw materials and components are
converted to in-process goods and in-process goods are converted to finished goods.
Manufacturing inventory is typically classified into raw materials, finished products,
component parts, supplies, and work-in-process. Independence of workstations is
desirable in intermittent processes and on assembly lines well. Organisations,
especially those in the FMCG and engineering goods, do not always produce their
output from the raw materials. Some of their components are bought from other
vendors.
Finished product or end-items, comprises of all the final products made by the
company, ready for shipment and sale. For financial reporting purposes, inventories are
treated as part of the working capital in the Balance Sheet.
Raw materials are those items purchased to be processed and are major inputs into
an organisation and form the bulk which gets converted into output. The function of raw
materials inventory is to act as a buffer between procurement and manufacturing. Work
in Process inventory consists of materials in various stages of semi-fabrication or
manufacture or assembly. They comprise of the semi-finished products formed at
various stages of the production process. WIP can also result due to faulty production
planning, where the capacities of all the processes are not considered properly.
Bill of Materials (BOM) should be drawn properly and informed to Procurement
division well in advance. As we all know, the Bill of Materials indicates when each
material is required and how much is required in the production process.
The cost of inventory consists of all the costs involved in buying and preparing
merchandise for sale. The cost of finished goods inventory is the total of the materials,
labour, and manufacturing overhead costs used in the production process for those
items.
Every inventory control measure starts with a focus on costs. Traditionally, the
entire marketing department has always focused on profit margins and completely
ignored the cost of carrying finished goods inventory. From a logistics management
perspective, transit inventory introduces two sources of complexity into the supply
chain. Vendor managed inventory results in dramatic inventory reductions across the
supply chain as there is only one inventory control point.

1. ___________ increase cost and reduce profitability
(a) Balanced Stock
(b) Buffer Stock
(c) Overstock
(d) Stock
2. ______________are parts or materials used to support the production process, but
not usually a component of the product.
(a) Supplies Inventory
(b) MRO
(c) Consumables
(d) Raw Material Inventory
Notes
3. The _____________ purchases large quantities from manufacturers and sells small
quantities to retailers
(a) manufacturer
(b) Wholesaler
(c) Businessman
(d) Marketer
4. For a retailer, inventory management is fundamentally a matter of ____________
and selling.
(a) Buying
(b) Learning
(c) Creating
(d) Displaying
5. A company may have several stock points or ____________ destinations across
the country.
(a) Manufacturing
(b) Purchase
(c) Supplies
(d) Storage
6. Most progressive companies have changed their procurement concept from 'when'
and ‘how many to order’ to ‘when’ and ‘how many to ___________’.
(a) Deliver
(b) Sell
(c) Purchase
(d) Manufacture
7. The ___________ requirement results from uncertainty concerning future sales and
inventory replenishment
(a) WIP Stock
(b) Raw Material
(c) Finished goods
(d) Safety Stock
8. VMI reduces ___________ and optimises inventory in the supply chain.
(a) Overstocking
(b) Stockouts
(c) Safety Stock
(d) Manufacturing Stock
9. ___________ Inventory represents stock that is either moving or awaiting
movement in transportation vehicles.
(a) Raw Material
(b) Buffer
(c) Transit
(d) Supplies
10. A ___________ inventory, or base stock, is the portion of average inventory that
results from the replenishment process.

(a) Bus
(b) Car
Notes
(c) Truck
(d) Cycle

1. Define Work in Process Inventory. What are the reasons responsible for a high WIP?
2. Discuss a few steps that can be adopted to control WIP.
3. What are Finished Goods Inventories? Who do you think should be the custodian of
Finished Goods Inventories and why?
4. What are the various approaches to ensure that finished goods inventories are within
reasonable limits?
5. What are the factors which influence the stocking of finished goods inventories?
6. Discuss the different types of inventory.
7. What are the advantages of vendor managed inventory?
8. Write a note on buffer uncertainties.
2.11 Key Terms

z Manufacturing Inventory: Manufacturing inventory is typically classified into raw
materials, finished products, component parts, supplies, and work-in-process.
Independence of workstations is desirable in intermittent processes and on
assembly lines well.
z MRO Inventory: In addition to inventories that directly support product creation,
other inventories are used indirectly. These are MRO items and include everything
from office supplies and forms, to toilet paper and cleaning supplies, to tools and
parts needed to repair machines.
z Contingency Stock: Inventory held to meet unexpected or unforeseen demand or
requirements.
z Logistics: The overall management of the way resources are obtained, stored and
moved to the locations where they are required.
z Supplier: A supplier, also called a vendor, is a person or company that provides
goods and/or services to other companies

1. (c) Overstock
2. (a) Supplies Inventory
3. (b) Wholesaler
4. (a) Buying
5. (d) storage
6. (a) Deliver
7. (d) Safety Stock
8. (b) Stockouts
9. (c) Transit
10. (d) Cycle

z Reji Ismail, Logistics Management, Excel Books, Delhi. Notes
New Delhi

Notes CASE STUDY

The Lowells’ Company is a manufacturer of electrical appliances for the consumer
market. Its major product line consists of several models of electrical switches for both
homes and offices. The switches division generates over 90% of the firm’s annual
sales, which was approximately Rs 30 crores last year. Over the years, the company
had earned the reputation of being a low cost good quality producer.
Several years ago, the company introduced a new model of the switch that was
extremely successful. The model was an advanced electronic switch which minimised
the chances of a shock. During the design stage of the product, the marketing
department had conducted an extensive survey to determine exactly what style and
colour combinations were desired by the consumer. The style finally selected was a
sleek futuristic contour in white and beige, with features of safety and cut-off.
From a cost and pricing point of view, the new product fitted the company’s basic
operating strategy very well. The firm typically priced its products 15-20% lower than its
major competitors. This pricing policy was made possible mostly because Lowell was
essentially a ‘design and manufacture’ type of operation that purchased its basic raw
materials and components in large volumes from large manufacturers and supply
houses. The capacity of production was huge, was largely automated; the production
planning and production were generally in line with the sales forecasts and the
expertise of the employees was good.
During the past 6 months, Lowell’s costs have been increasing at a level
significantly higher than the producer price index for their own finished goods. In-
process inventories have also increased significantly, coupled with loss of production
and increase in indirect labour costs. Breakdowns seemed to be occurring more
frequently. Consequently, the firm’s profit margin and its return on investment had
begun to drop noticeably.
A section of the Board suggested a 5-10% increase in prices. But the Vice
President-Sales opposed it vehemently as he thought it would vitiate the image of the
firm as a low cost high quality producer. He said this could result in an erosion of the
company’s customer base.
A high level team was constituted to look into the problems in the firm.
1. List the findings of the team.
2. Prepare a report listing what should be done by the company to affect a turnaround.
3. What reports should the management receive on a regular basis to prevent a
recurrence of such events in future?

Selective Inventory Control 33
Unit 3: Selective Inventory Control

Notes
Structure
3.1 Introduction
3.2 Concept of Selective Inventory Control
3.2.1 ABC-Classification for Inventory Control
3.3 Inventory Categorization
3.4 Inventory Control through Inventory Classification
3.5 Inventory Performance Analysis
3.5.1 Perpetual Review System
3.5.2 Periodic Review System
3.6 Inventory Coding System
3.7 Standardisation
3.7.1 Objectives
3.7.2 Benefits
3.7.3 Types
3.8 Summary
3.11 Key Terms
Objectives
z Understand the concept of selective inventory control
z Discuss the inventory control through inventory classification
z Explain the inventory performance analysis
3.1 Introduction
Recent industry reports show that inventory costs as a per cent of total logistics costs
are increasing. Despite this rise, many organizations have not taken full advantage of
ways to lower inventory costs. There are a number of proven strategies that will provide
payoff in the inventory area, both in customer service and in financial terms.
Some of these strategies involve having fewer inventories while others involve
owning less of the inventory. ERP and information technology solutions have been able
to provide solutions, not only for inventory management but also for aggregate planning,
material requirement planning and operations scheduling.
In principal each individual item can be controlled in a unique way. Since, there are,
in general, several thousands of items; this is not a practical solution. It is much easier
to divide the items into number of groups and use the same forecasting and inventory

control techniques for all items in the same group. For selective inventory control, items
are categorized in ABC classes. However, demand of some of the B or C class items
Notes may have an impact on the demand of some A class items. Shortages on such B or C
class items can cause severe reductions in the demand of dependent A items and
resulting in lost sale of items. Association rules mined from the sale transaction data
can be used to find these interdependencies in demand. It is suggested that such
unimportant or less important items should be treated at par with the A-class items for
the purpose of inventory control.
3.2 Concept of Selective Inventory Control

Inventory control is a function of materials management, and the objective is to keep the
total cost associated with the system to a minimum. This requires familiarity with supply
sources, price negotiations including bulk quantity discounts, modes of transportation,
budgeting, and physical handling, record keeping, and monitoring the incoming quality
of items. In real life situations, we have a very large number of items in an inventory. It
may not be possible to review (which includes computing inventory-on-hand, placing
orders, receiving stock, etc.) such a large number of items with equal intensity. Review
activities take time and cost money. Hence items are usually classified into important
and less important groups. The important ones get more attention than the others. The
goal is to keep stocks at low level while giving good service.
Out of thousands of items held in an inventory of a typical organization, only a small
percentage of them deserve management’s closest attention and tightest control. As all
items need not be considered equally for inventory management and control, relative
importance of material or an item to the organization is an important issue. This has
given rise to selective inventory control in the organizations. Most widely-used
technique used to classify items for the purpose of selective inventory control is ABC
classification. A discussion on ABC-classification is as given below.
3.2.1 ABC-Classification for Inventory Control

The ABC-classification process is an analysis of a range of items or products in the
inventory into three categories: A—outstandingly important and require the highest level
of control, supervision and management; B—of average importance and require
medium level of control, supervision and management; C—relatively unimportant as a
basis for a control scheme and don’t require elaborate control/management, as the cost
and effort of control is not worth of it. Hence, each category can and sometimes should
be handled in a different way, with more attention being devoted to category A, less to
B, and the least to C.
The ABC-classification system is about grouping the items according to monetary
value of annual sales or demand, in an attempt to identify the small number of items
that will account for most of the sales volume and that are the most important ones, i.e.
A-class items, to control for effective inventory management. It is governed by the
Pareto principle in quality which segregates the vital few from trivial many. ABC-
analysis technique is the equivalent of creating a Pareto Chart for identifying the causes
of defects in quality management, except that it is applied to inventory rather than
quality. It has been observed, in general, about 15-25 per cent of the items account for
60-80 per cent of total annual demand/consumption value of all items—these are
termed as ‘A’ class items. About 15-30 per cent of items account for 15-20 per cent of
the total annual demand/consumption value of all items—these are termed as ‘B’ class
items. The remaining approximately 50-70 per cent of the items accounting for around
5-15 per cent are classified as ‘C’ class items. Because A-class of items constitutes a
major proportion of the annual revenue, an optimal inventory control policy for the A-
class items should be pursued. For example, these items should be monitored
continually and more sophisticated forecasting tools can be adopted. A manager can
direct that class-A items be reviewed continually to reduce the average lot size and
keep inventory records current. If the records show an on-hand balance of 100 units but
the actual balance is 200 units, costly inventory is being carried needlessly. Precise

mathematical models for determination of EOQ (economic order quantity), high
frequency of purchase, safety stock/buffer stock level, etc. can be used for these items.
Cost reduction is achieved through centralized purchasing, switching suppliers, or more Notes
effective contract negotiation.
For C-class items, much looser control is appropriate. A stock out of a class-C item
can be as crucial as for a class-A item, but the inventory holding cost of class-C items
tends to be low. These features suggest that higher inventory levels can be tolerated
and that more safety stock, larger lot sizes, or perhaps even a visual system may
suffice for class-C items. Hence, C-items can be overstocked, if necessary, so that little
or no control is exercised on these items. Large lot sizes of C-items can also be used to
minimize the frequency of ordering while exercising a minimum degree of control.
Judgment is exercised in handling B-items. Different inventory control practices
exist for B-items. One practice is that some of these items are treated like A-items
while, rest are treated like C-items. Another practice is that all the B-class items can be
reviewed periodically and these items can be ordered in groups rather than individually.
Different cycle time is used for different group of items.
However, we can not afford to overstock the items which are unimportant as per
ABC-classification beyond a certain extent. We need to exercise some control on such
items which will lead to low cost of inventory and more profitability. The unavailability of
many such items also leads to loss of huge profit. Inventory control of so-perceived
unimportant items has several dimensions. Interdependency in the demand pattern of
the items gives rise to one such dimension where the demand of an unimportant item
belonging to C-class (or, B-class) causes the demand of an important item or an A-
class item. Hence inventory control of such unimportant items is also important and
their unavailability results in several losses related to the interdependency aspects with
other important A-class or H-class items. It happens for such items when in their
absence, customers many a times are reluctant to purchase an item or items of A-class.
This leads to loss of profit earning from the sale of important items in retail sale
business. Not only that, inventory of many important items remains idle in the absence
of so-perceived unimportant items. Hence, it leads to higher inventory holding cost
along with the loss of profit from sale. The challenge is how to manage so-perceived
less important items having an impact on the demand of some of the important A items.
3.3 Inventory Categorization

Before beginning, any kind of classification of inventories, it is necessary to have a list
of all the items in the inventory. This list should ideally contain:
z An identifiable individual number or a code for each item – Various methods of
codification are in use in the industry – numeric, alpha numeric etc.
z The description of the item. This should include the dimensions, weight, identity of
the mother equipment, drawing numbers, part number, etc.
z Annual consumption of at least the last three years
z Names of suppliers who have supplied the item in the last three years
z Average life of the item
z Stock of the item
Such a list of items in the inventory is called the Inventory Catalogue.
The inventory catalogue serves many purposes. A seasoned storekeeper can see
the code number and identify the item. It helps to identify similar items in the inventory
and helps in standardization and variety reduction. When it comes to computerisation of
the inventory records, the catalogue number becomes the identifying number for an
item. By logging in the catalogue number, the history of an item can be known.

3.4 Inventory Control through Inventory Classification

Notes Regardless of which technique or solution one employs, proactive inventory
management practices make a measurable difference in operations. A use of proper
classification inventory system could help to do selective inventory control more
precisely. Let us now get to know what the various ways inventory can be classified are:
1. ABC Analysis: This is the most commonly used method of classification. This
classification is based on the annual consumption value of the items and is most
commonly used. It goes by the principle of “Vital few, trivial many”. It is often seen
that a small number of items account for a major portion of the total expenditure;
and there are often several items which together are many in number but account
for a small portion of the annual expenditure. The actual percentages vary from one
firm to another, but it can be taken as a general rule that 10% of the items account
for 70% of the cost. They are called the “A” class items and require maximum
attention. Similarly, around 70% of the items account for only 10% of the cost. They
are called the “C” class items and should not be given too much attention. The
remaining items are called the “B” class items.
The ABC analysis is also called the Pareto Analysis, developed by the Italian
economist Vilfredo Pareto.
When graphically represented, it appears as follows:
100 –
%age of
total 80 -
inventory
investment 60 -
40 -
20 - A B C
| | | | | |
20 40 60 80 100
%age of no. of items in Inventory
Figure 3.1: A-B-C Analysis

This analysis is easy to conduct. As a first step, once the items in the inventory
have been properly identified, their usage record for a complete operating cycle is
built. Usually, the operating cycle is one year, for most companies. Then the items
are sorted and ranked in the decreasing order of their consumption value. The
value of each item is next expressed as a percentage of the total.
By going down the list and successively cumulating the individual percentages
for each item, one can determine which items make up the first 70% of inventory
investment, the next 20% and the balance 10%. The groups are called A, B and C
respectively and the items within the group are called the A, B or C item.
Such a classification is of immense importance to the management. It provides
them the logic on how to allocate funds and time of personnel with respect to
procurement as well as refinement of control over the individual inventory items. It
would be a waste of time and effort to pay as much attention to C class items as to
A class items. Hence separate policies are usually adopted for A class items and C
class items. While A class items need to be monitored on day-to-day basis, decision
is taken on C class items based on the objectives of minimising acquisition cost,
maximising service and reliability, minimising inventory investment, minimising
indirect costs associated with inventory and utilising personnel and their time
effectively. Notes
2. XYZ Analysis: This classification is based on the stock value of the items. Items
having a very high stock value are classified as ‘X’. Items with least stock value are
classified as “Z”.
The method of arriving at the classification is the same as for ABC classification
described above. Only, instead of taking the annual consumption value into
account, the annual stock value for each item should be taken into account. The
rest of the procedure is the same.
The value of each item is expressed as a percentage of the total. By going down
the list and successively cumulating the individual percentages for each item, one
can determine which items make up the first 70% of inventory stock value, the next
20% and the balance 10%. The groups are called X, Y and Z respectively and the
items within the group are called the X, Y or Z item.
3. VED Analysis: Certain items are important by their absence and not by their
presence. If not available, they can cause a holdup in production and result in high
costs, shut down or slow down of production. These items may or may not be
priced high but their stock out costs are indeed very high. These items are called
the “Vital” items. The “E” stands for “Essential”. Although these items are not very
critical to production, their stock outs are still expensive. The “D” stands for
“Desirable” – it is better to avoid stock outs for these items, although a stock out for
a short period will not affect the production.
This classification is essentially done on the basis of shortage costs of the
material.
Various forms of VED classification exist. James A.G. Krupp, Director of Corporate
Materials at Echlin Inc had classified the materials in his organization according to
it’s service or operating importance on a 3-point scale:
(a) Critical
(b) Medium
(c) Non-critical
All the items in the inventory would fall in 1, 2 or 3 scales.
4. FSN Analysis: Items can also be classified as fast moving, slow moving or non-
moving based on their pattern of issue from the Stores. This denotes how soon a
material is consumed after it has been purchased and taken into stock. This
classification helps in controlling obsolescence.
Items that are very fast moving and are used once in every week or say, every
month are classified as “F”. Items which are not consumed even once in say two or
three years are classified as Non-moving- “N”. Keeping too many non-moving items
in the inventory is dangerous. They block useful working capital and eat into the
profitability of the company. Attention needs to be paid to
them to declare them as surplus or obsolete and find alternate uses of the
material or else dispose them off, so that it leads to money realization as well as
space saving.
All items which are neither “Fast” nor “Non-moving” are termed as “Slow Moving”
items.
This classification is again of great importance to companies who need to keep a
check on where their money is spent.
5. PQR Classification: Besides value and criticality of the items, another commonly-
used method to classify items is based on the shelf life of the item. Shelf life is
defined as the useful life of an item that is the time period within which the item can
display the complete characteristics, for which it is meant. Items having a low shelf
life and thus requiring frequent attention are classified as “P”. Items having the
Notes longest shelf life and thus requiring the least attention are classified as “R”. All the
other items which are not P or R fall within “Q”. The time period in which to define P,
Q and R varies from industry to industry. This classification is more relevant in
industries producing perishable goods such as confectionaries, etc.
6. SDE Classification: This classification is based on the ease of obtaining an item. S
stands for Scarce – such items are not easily available in the market and might
require source development or else it might be an item which is difficult to
manufacture or there are only one or two known manufacturers who have to be
given orders several months in advance and so on. All these require special efforts
for procurement. D stands for Difficult to obtain and E for Easy to obtain. An item
which is A as well as S needs completely different methods for inventory
management.
7. GOLF Classification: This classification is based on the nature of the source for an
item. G stands for “Government”, O for Open market, L for Local and F for foreign
sources of supply. Items which are canalised through the State Trading
Corporations, Minerals and Metals Trading Corporation, etc. come under the G
category. They require special procedures for procurement and as such common
procedures for Inventory management may not be fully applicable for them. The
transactions require more paperwork and lead times are longer. For ‘O’ items, there
are a number of suppliers. Quality and availability is good. Most big organisations
depend on the local market only for emergency supplies and
low value procurement. For ‘F’ the source of supply is abroad; this involves
considerable paperwork and lead time is high.
8. SOS Classification: This classification is based on the nature of the time of
availability for an item. S stands for Seasonal and OS for Off-Seasonal. This is
more relevant in case of items which are derived from nature – such as jute, cotton
etc. which are available more during their harvest time and less available during the
monsoons when it rains. They require separate purchasing and stocking strategies.
The inventory management system will have to balance out between the stocking
cost and lower prices at which it will be available. ‘OS’ items are ordinary items
which are not seasonal and can be subject to any other classification for selective
control.
9. HML Classification: This classification is based on the unit price of material. H
stands for High, i.e. high price per unit of the item, M stands for Medium and L for
Low unit price of the item. This classification is particularly relevant when it comes
to deciding the procedure to be followed for procurement.
3.5 Inventory Performance Analysis

There are two major variables in an inventory control system. They are the order
quantity and the frequency of ordering. The perpetual review system holds the order
size constant and lets the frequency of ordering fluctuate according to demand
requirement. The periodic review system holds the frequency of ordering constant by
establishing a fixed order period and let the order size fluctuate according to demand
requirement.
3.5.1 Perpetual Review System

z The stock position is monitored after each transaction (or continuously).
z When the stock position drops to the re-order point, a fixed quantity ‘Q’ is ordered.
z Excellent for high cost items needing close attention.
Advantages
z An efficient, meaningful order size.

z Safety stock needed only for the lead-time period.
z Less attention for slow moving items.
Notes
z Relatively insensitive to forecast and parameters change.
Disadvantages
z Requires perpetual auditing of inventory in stock.
z Prevents the economics, which result from the amalgamation of several items from
one supplier into one order.
3.5.2 Periodic Review System

z The stock position is reviewed at fixed intervals.
z An amount equal to a target inventory T minus the stock position is ordered after
each review.
z The periodic system is well suited for inventory control when there is one central
supplier and items are expensive.
z Compared to the perpetual system;
It does not have reorder point but rather a target inventory.
It does not have an Economic Order Quantity, since the quantity varies
according to demand.
The order interval is fixed, not the order quantity.
Advantages
z Multiple items can be ordered from the same supplier and delivered in the same
shipment.
z Less record keeping due to scheduled replenishment.
Disadvantages
z Requires safety stock for protection against demand fluctuations during both the
review period and the lead-time.
z This results in a larger safety stock as compared to the perpetual system.
3.6 Inventory Coding System

The inventory of any company has lakhs and lakhs of items, which will only keep
increasing if steps are not taken to reduce them. To begin the process of reduction, the
first step required is to uniquely and unambiguously identify each and every one of the
items. This is done by allotting a number to each item called a code. The process is
called codification. The logic is exactly similar to allotting a PAN number to every
income tax payer in India. Through this number, it is possible to locate the history of
every tax payer is assesed in India. The code would consist of digits or alphabets or
both. The system should enable easy identification of the nature of the item, should
ensure uniqueness and should also enable us to locate the item from the nature and full
description of the item. It is important that the code number is allotted on the basis of
the intrinsic characteristics of the item, irrespective of how or where it is used or who is
using it. The advantages of codification are:
1. Duplicate stocks under different descriptions for the same item are avoided.
2. Accurate identification of items by all consumer departments and customers/users
is made possible.
3. Posting of receipts, issues, accounting records etc. in a systematic manner is now
possible.
4. Accuracy in posting of receipts, issues, accounting records etc. is possible.

5. Codification is the fundamental requirement for computerization of Materials

Management activities.
Notes 6. It helps in standardisation and variety reduction.
Two examples of codification systems are the Brisch system and Kodak system.
They are 7-digit and 10-digit systems respectively. Each organisation develops its own
system of codification based on its number of items and characteristics of items. Before
beginning the process of codification, the organisation must carefully review all items on
its existing and proposed inventory and then proceed with allotting the code numbers.
Care must be taken to ensure that there are no unnecessary items or duplicate/multiple
identifications and the number of different unique items is absolutely necessary.
The simplest form of codification can be seen in the system of ‘Tiffin-Carriers’ or
‘Dabbawallahs’ of Mumbai. Each dabbawallah handles over 35 lunch boxes a day and
together they deliver over 2, 00,000 lunch boxes daily, over a radius of 60-70 kms in
Mumbai. Initially, the ‘box identification system’ was a unique coding system wherein
the dabbawallahs would tie coloured threads, cloth swathes or cutting to identify and
separate the boxes, along with symbols such as +, = and #, various versions of Hindu
swastika, or triangles, circles and squares.
But as the number of boxes grew exponentially, this system was found to be
inadequate. So a system was devised in the early 1970s which involves colour, coding
of alphabets, with a maximum of seven basic VIBGYOR colours signifying the group
handling the boxes and signifying the point of origin and point of destination. 10-9/M/16
would translate to 10 being the destination i.e. Nariman Point in South Mumbai, 9 is the
specific area in Nariman Point, M for Mittal Towers and 16 for the 16th Floor. This
simple system has won Mumbai’s dabbawallahs the coveted Forbes’ Six Sigma
certification.
3.7 Standardisation
The dictionary meaning of standardisation states that it is an activity that provides
solutions for repetitive applications to problems essentially in the spheres of science,
technology and economics, aimed at the achievement of the optimum degree of order in
a given context. Generally, the activity consists of the process of formulating, issuing
and implementing standards.
According to the International Standards Organisation (ISO), “Standardisation is the
process of formulating and applying rules for an orderly approach to a specific activity
for the benefit and with the cooperation of all concerned, and in particular for the
promotion of optimum overall economy, taking due account of functional conditions and
safety requirements.”
Standardisation is a tool to promote the use of minimum number of parts to serve
the maximum number of purposes, in order to achieve economy in manufacture,
minimise whole life costs and maintain the quality and reliability necessary to ensure
operational effectiveness and efficiency. While standards and standardisation are
concerned with ‘objects’ and ‘actions’, our interest would be with ‘objects’ only.
Standardization is achieved through the process of Variety Reduction that is
reducing the numbers, sizes and categories of a given product or item and still meeting
almost the entire range of demands of the customers. Simplification on the other hand
is the process of making the design simple but standardization is the process where the
same standard part is fixed in many varieties of the product–different size, shape etc.
3.7.1 Objectives
The aims of standardisation are:
z Foster trade in the country and outside
z Protect consumers

z Answer to the needs of developing industries
z Assure interfacing interchangeability, compatibility or interworking
Notes
z Integrate safety and health; protect the environment
3.7.2 Benefits
Some of the benefits of standardisation are:
z The use of standard specification enables the supplier to understand buyers’
requirement and quote the correct price and correct quality.
z It will improve the quality of the end product.
z It will lower the cost of production, as non-standard parts would be costlier.
z In the case of manufactured parts, the varieties and types of machinery required for
manufacture of parts involved or reduced.
z Standardisation of individual components of a product results in a smaller range of
spares being carried for after-sales-service to customers.
z It will enable the reduction of varieties.
3.7.3 Types
There are four types of standards:
(a) International Standards: e.g. ASTM (American Society of Testing and
Materials), ASME (American Society of Mechanical Engineers), BS (British
Standards), JIS (Japanese Industry Standards), etc.
(b) National Standards: e.g. BIS (Bureau of Indian Standards)
(c) Industry Standards: e.g. IPSS (Interplant Standards Sub-committee for Steel
Industry) etc.
(d) Company Standards: They are applicable company-wide which may include
some of the earlier three types of standards and go beyond.
3.8 Summary
The “Pareto Principle”, in simple terms states that a few activities in a group of activities
or a few items in a group of items made, purchased, sold or stored, account for the
larger part of the resources used or gained. This characteristic, which is also referred to
as the 80:20 principle is exhibited by most inventories and can be usefully utilised to
focus management effort and attention on such items as are expensive, fast moving,
vital or difficult to obtain. Several variations of this basic technique are available and can
be applied for segmentation of inventories for differential treatment. The ABC analysis,
uses this principle to divide inventories into three classes according to funds usage. A
items, which represent about 10% of the total inventory range but account for almost
70% of the usage value, call for a tight control system. Order quantities and order points
are carefully determined. Close attention is paid to record accuracy. Variables are
reviewed each time an order is placed. B items, which constitute about 20% of the total
inventory range and account for 20% of the annual usage value, require normal
controls. Variables can be reviewed periodically. C items are the remaining 70% of the
inventory which involve only about 10% of the usage value. Relatively loose controls
and less frequent reviews suffice in their case. Other variants of this technique are the
Vital, Essential and Desirable (VED), a classification based on criticality and Fast, Slow
and Non-moving (FSN) items where there movement pattern determines their
classification. These classifications can be used either individually or in combination
with each other. There are two major variables in an inventory control system. They are
the order quantity and the frequency of ordering The inventory of any company has
lakhs and lakhs of items, which will only keep increasing if steps are not taken to reduce
them. To begin the process of reduction, the first step required is to uniquely and
unambiguously identify each and every one of the items. This is done by allotting a

number to each item called a code. The process is called codification. Standardisation
is a tool to promote the use of minimum number of parts to serve the maximum number
Notes of purposes, in order to achieve economy in manufacture, minimise whole life costs and
maintain the quality and reliability necessary to ensure operational effectiveness and
efficiency.

1. Inventory control is a function of materials management, and the objective is to
keep the total _______ associated with the system to a minimum.
(a) Cost
(b) profit
(c) loss
(d) None of these
2. Out of thousands of items held in an inventory of a typical organization, only a small
percentage of them deserve _____________ closest attention and tightest control.
(a) supplier’s
(b) Storekeeper
(c) Management’s
(d) Production manager
3. The ABC-classification system is about grouping the items according to
_____________ value of annual sales or demand
(a) Cost
(b) Monetary
(c) Production
(d) Storage
4. For C-class items, much __________ control is appropriate.
(a) Looser
(b) Stricter
(c) Rigid
(d) Conventional
5. Items having a very high stock value are classified as ‘X’. Items with least stock
value are classified as _________.
(a) A
(b) Z
(c) D
(d) E
6. In____________ classification is based on the nature of the source for an item.
(a) GOLF
(b) HML
(c) VED
(d) ABC
7. The ________________ system is well suited for inventory control when there is
one central supplier and items are expensive.
(a) Perpetual

(b) ABC
(c) FSN
Notes
(d) Periodic
8. _____________ is a tool to promote the use of minimum number of parts to serve
the maximum number of purposes.
(a) Codification
(b) Standardisation
(c) Simplification
(d) Categorization
9. A use of proper classification inventory system could help to do _____________
inventory control more precisely.
(a) Overall
(b) Simplest
(c) Selective
(d) Complex
10. _____________ method is used to classify items based on the shelf life of the item.
(a) SOS
(b) HML
(c) ABC
(d) PQR

1. Illustrate with examples wherever possible, some typical cases where inventory
management based on unscientific methods could go wrong.
2. It is often said that the base of inventory is the large number of items. Explain this
and discuss a few ways how it can be reduced.
3. What is standardization? How does standardization lead to variety reduction?
4. Why is it necessary to control inventories? What are the techniques available for
Inventory Control?
5. “Small is beautiful”. Discuss this statement in the context of inventories. How can
you make inventories beautiful?
6. Define Standardisation and explain its importance in inventory control.
7. Distinguish between ABC analysis and VED analysis.
8. Write short notes on:
Selective inventory control
VED classification
XYZ analysis
GOLF classification
HML classification
3.11 Key Terms

z ABC-classification: ABC Classification process is an analysis of a range of items
or products in the inventory into three categories: A-outstandingly important and
require the highest level of control, supervision and management; B-of average
importance and require medium level of control, supervision and management; C-
relatively unimportant as a basis for a control scheme and don't require elaborate
control/management, as the cost and effort of control is not worth of it. Hence, each
category can and sometimes should be handled in a different way, with more
Notes attention being devoted to category A, less to B, and the least to C.
z Inventory categorization: A list of all the items in the inventory is helpful in
categorizing inventories. The list contains an identifiable individual number or a
code for each item, the description of the item, annual consumption of at least the
last three years, names of suppliers who have supplied the item in the last three
years, average life of the item and stock of the item.
z Inventory Coding: The inventory of any company has lakhs and lakhs of items,
which will only keep increasing if steps are not taken to reduce them. To begin the
process of reduction, the first step required is to uniquely and unambiguously
identify each and every one of the items. This is done by allotting a number to each
item is called a code and the process is called codification or inventory coding.
z Inventory performance: Inventory Performance measurement is a requirement as
it would reveal as to how good or bad is the inventory management being carried
out by an organization. It would also provide an opportunity for comparing various
performance indicators with same of the benchmark company in similar industry.
z SOS Classification: This classification is based on the nature of the time of
availability for an item. S stands for Seasonal and OS for Off-Seasonal.

1. (a) cost
2. (c) management’s
3. (b) monetary
4. (a) looser
5. (b) Z
6. (a) GOLF
7. (d) periodic
8. (b) Standardisation
9. (c) Selective
10. (d) PQR

z Reji Ismail, Logistics Management, Excel Books, Delhi.
New Delhi

Inventory Costs 45
Unit 4: Inventory Costs

Notes
Structure
4.1 Introduction
4.2 Importance of Identifying Inventory Costs
4.3 Types of Inventory Cost
4.3.1 Holding (or carrying) costs
4.3.2 Cost of ordering
4.3.3 Setup (or production change) costs
4.3.4 Shortage or stock-out costs or Under Stocking Costs
4.3.5 Overstocking cost
4.3.6 Total Acquisition cost
4.4 Inventory Metrics
4.5 ABC (Activity Based Costing)
4.5.1 Limitations of ABC
4.6 Summary
4.9 Key Terms
Objectives
z Understand why identifying inventory costs is important
z Discuss the different types of inventory costs.
z Explain the Activity Based Management.
4.1 Introduction
We have seen that inventory is an idle resource provided that it has economic value. In
the context of materials management, inventory is made up physical entities or items of
material. While many consider inventory as a liability, the financial pundits have chosen
to treat is as an asset and that too a current one, and show it in the Balance Sheets as
part of Working Capital. While materials don’t work, they make everyone work and since
no one works for free, materials or inventory spells money or costs. While every item in
the inventory has been acquired at a price, which is known and tangible, there are
hidden costs connected with inventory. Even among these hidden costs, there are
some that are more easily apparent and some others that are really hidden. During
everyday operations, several points of conflict emerge between functional areas, such
as:
z Purchasing wants to buy large quantities of materials to take advantage of purchase
discounts, but if the purchases are made, the stockrooms will end up carrying
excessive inventory.

z Quality inspectors are responsible for ensuring that only good quality products are
shipped.
Notes z Workers may push their machines and tools beyond specific limits to increase the
quantity produced in a period. However, their actions will affect machine
breakdowns and tool wear and tear, creating an additional load for maintenance
departments, apart from the additional maintenance costs involved.
z When faced with a change in schedule, materials planners are more readily inclined
to expedite jobs than to de-expedite them. Work centers become overloaded with
work, some of whose due dates no longer remain valid.
The above said conflicts also end up with creating inventory costs. As we all know,
inventory is a cost. This means there are several costs associated with holding
inventories. In this chapter different types of costs associated with inventory is
discussed.
4.2 Importance of Identifying Inventory Costs

The heart of inventory decisions lies in the identification of inventory costs and
optimising the costs relative to the operations of the organisation. Therefore, an
analysis of inventory is useful to determine the level of stocks. The resultant stock
keeping decision specifies:
1. When items should be ordered?
2. How large the order should be?
3. “When” and “how many to deliver.”
It must be remembered that inventory is costly and large amounts are generally
undesirable. Inventory can have a significant impact on both a company’s productivity
and its delivery time. Large holdings of inventory also cause long cycle times which may
not be desirable as well. What are the costs identified with inventory?
4.3 Types of Inventory Cost

The costs generally associated with inventories are carrying costs, procurement costs,
ordering costs and stock-out costs. The different components of inventory costs are
discussed further in different sub-heads.
4.3.1 Holding (or carrying) costs

It costs money to hold inventory. Such costs are called inventory holding costs or
carrying costs. This broad category includes the costs for storage facilities, handling,
insurance, pilferage, breakage, obsolescence, depreciation, taxes, and the opportunity
cost of capital. Obviously, high holding costs tend to favor low inventory levels and
frequent replenishment.
There is a differentiation between fixed and variable costs of holding inventory.
Some of the costs will not change by increase or decrease in inventory levels, while
some costs are dependent on the levels of inventory held. The general breakdown for
inventory holding costs has been shown in Table 6.4.
TA B L E 4.1
Fixed and Variable Holding Costs
Fixed costs Variable cost
Capital costs of warehouse or store Cost of capital in inventory
Cost of operating the warehouse or store Insurance on inventory value
Personnel costs Losses due to obsolescence, theft, spoilage
Cost of renting warehouse or storage space

Inventory Costs 47
When inventory is stored, we are actually storing company’s money, which attracts
a huge interest rate. It comprises of five major cost elements. They are:
z Opportunity costs: When a firm spends a certain amount of money and buys a
Notes
certain quantity of material and keeps the same in its inventory, it has that much
less money to spend for other purposes. Had this money been invested in
productive equipment or in external securities, it would have earned a return for the
company. This income which the company foregoes on account of blocking the
money in inventory is called the ‘Opportunity cost’ associated with inventory
investment. It is a notional cost.
z Insurance costs: Most firms insure their inventory against fire or any other forms of
damage. More the inventory more is the amount of money that is needed for
insurance.
z Property taxes: As we have already read, inventory is an asset. Property tax is
levied on a firm’s assets, so therefore property tax is levied on inventory as well.
More the inventory, greater is the asset value, therefore greater is the tax liability.
z Storage costs: More the inventory more is the cost of storing the material. More
space is needed to store the material, this call for more rent, more money spent on
acquiring the land, more money spent on building the sheds, racks, tarpaulin covers
and other preservation items, pest control, etc. Moreover, the warehouse in which a
firm stores its inventory is depreciated by a certain percentage every year, over the
length of its life. One may say then, that the cost of warehouse space is a certain
amount of money per cubic meter per year. This cost is conceptually charged
against inventory occupying the space. Besides these costs, there is also the cost
incurred on facilities such as electricity, water, maintenance, salaries of stores staff,
security services etc. which are all part of the storage costs.
z Obsolescence cost: In any inventory, there is always a certain amount of stock
that is damaged, broken, pilfered, deteriorated, evaporated, shelf life expired and
obsolete. No matter how diligently the storekeeper may guard against these
occurrences, a certain amount always takes place. With new products being
introduced in the market frequently, obsolescence also occurs very fast.
Obsolescence can also take place due to discontinuation of product line, change in
design, change in machinery/equipment and existence of spare parts when
machines are scrapped. Consequently, more the inventory, the greater is this loss.
In the present day scenario, carrying costs account for around 30% of the value
of the inventory, with its five major elements contributing as follows:
Opportunity costs - 15-20%
Insurance cost – 2-4%
Property taxes – 1-3%
Storage costs – 1-3%
Obsolescence and deterioration – 5-10%
It is seen that larger the order that is shipped at a time, higher would be the average
inventory level during the period covered by the order. Since inventory carrying
costs vary directly with the size of the inventory, they are therefore higher.
4.3.2 Cost of ordering

Although it costs money to hold inventory, it also, unfortunately, costs to replenish
inventory. These costs are called inventory ordering costs. Ordering costs have two
components:
1. One component that is relatively fixed, and
2. Another component that will vary.

It is good to be able to clearly differentiate between those ordering costs that do not
change much and those that are incurred each time an order is placed. The general
Notes breakdown between fixed and variable ordering costs is as follows:
T A B L E 4.2
Fixed and Variable Ordering Costs
Fixed costs Variable costs
Staffing costs (payroll, benefits, etc) Shipping costs
Fixed costs on IT systems Cost of placing and order (phone, postage, order forms)
Office rental and equipment costs Running costs of IT systems
Fixed costs of vendor development Receiving and inspection costs
Variable costs of vendor development
One major component of cost associated with inventory is the cost of replenishing
it. If a part or raw material is ordered from outside suppliers, and the organisation places
orders for a given part with its supplier three times per year instead of six times per
year, the costs to the organisation that would change are the variable costs, and which
would probably not are the fixed costs.
There are costs incurred in maintaining and updating the information system,
developing vendors, evaluating capabilities of vendors. Ordering costs also include all
the details, such as counting items and calculating order quantities. The costs
associated with maintaining the system needed to track orders are also included in
ordering costs. This includes phone calls, typing, postage, and so on.
Though vendor development is an ongoing process, it is also a very expensive
process. With a good vendor base, it is possible to enter into longer-term relationships
to supply needs for perhaps the entire year. This changes the “when” to “how many to
order” and brings about a reduction both in the complexity and costs of ordering. It is
also known as acquisition costs. These costs include:
z Portion of the wages and operating expenses of departments such as purchasing
and supply, production control, receiving, inspection, stores and accounts, which
are involved in the procurement process.
z Cost of supplies such as stationery, engineering drawings, envelopes and forms
used in departments such as purchasing and supply, production control, receiving,
inspection, stores and accounts, which are involved in the procurement process.
z Cost of services such as computer time, fax, telephone, postage, courier,
advertisements, travel, negotiations, entertainment etc.
z Cost of source development.
z Rent and depreciation of the space utilised by Purchase Department.
z Receiving and inspection costs, cost of effecting payment.
Acquisition costs are not directly related to the size of the inventory per se; they
are a function of the number of orders placed or deliveries received during a given
period of time.
Calculation of Ordering Costs

The inventory carrying costs can be worked out as follows:
Carrying cost/year = (Average Inventory value) × (inventory carrying cost as a
percentage of inventory value)
(Carrying cost/year) = (Average inventory) × (material unit cost) × (inventory
carrying cost as a percentage of inventory value)

Inventory Costs 49
Q
CC = × C ×1
2 Notes
Where CC = Carrying cost per year for the material in question
Q = Ordered of delivered quantity for the material in units
C = Unit cost of the material delivered
I =Inventory carrying cost of the material, expressed as a percentage of the
inventory value
(Average inventory can be calculated by averaging the inventory of the 12 months
in a year or by adding the opening and closing inventories of a year and dividing them
by 2)
For a certain amount of annual usage of an item, the number of orders placed
during a year will decrease as the annual order quantity increases, thus generating
lower acquisition costs. The annual acquisition costs associated with order quantities of
various sizes can be calculated as follows:
Total cost incurred

(Ordering cost per Purchase Order) =
Total no. of orders
(Acquisition cost/year) = (No. of orders placed/year) × (Acquisition )cost/order
U
or AC = ×A
Q
Where AC = Acquisition cost/year for the material in question
U = Expected annual usage of the material, in units
Q = Ordered or delivered quantity of the material, in units
A = Acquisition cost/order or per delivery of the material
Example 1: Calculate ordering cost and inventory carrying cost for a company given
the following annual data:
Purchase Department expenses ` 2,00,000/-
Stores Personnel expenses ` 2,00.000/-
Obsolescence ` 60.000/-
Rental charges of warehouse ` 1,40,000/-
Collection cost ` 40,000/-
Receiving cost ` 35,000/-
Inspection cost ` 50,000/-
Stores material handling costs ` 1,60,000/-
Bill payment expenses ` 75,000/-
Interest charges14.5 %
Insurance charges 2.0 %
Number of orders placed 5000
Average total inventory ` 100 lakhs

Solution:
Notes (a) Ordering Costs
Purchase Department expenses ` 2,00,000
Collection cost ` 40,000
Receiving cost ` 35,000
Inspection cost ` 50,000
Bill payment expenses ` 75,000
Total ` 4,00,000
No. of orders/year 5,000
4,00,000
Ordering Cost = = ` 80/-
5,000
(b) Inventory Carrying Costs
Stores Personnel expenses ` 2,00,000
Obsolescence ` 60,000
Rental charges of warehouse ` 1,40,000
Stores Material handling costs ` 1,60,000
Insurance costs ` 2,00,000
Interest charge @ 14.5%
on ` 100 lakhs ` 14,50,000
Total ` 22,10,000
Total Inventory Mgt Cost
Inventory Carrying Cost = × 100
Average Inventory
22,10,000
= × 100
1,00,00,000
= 22.1%
Ordering costs and inventory carrying costs are used in calculating economic order
quantities.
4.3.3 Setup (or production change) costs

In the case of sub-assemblies, or finished products that may be produced in-house,
ordering cost is actually represented by the costs associated with changing over
equipment from producing one item to producing another. This is usually referred to as
setup costs.
Set-up costs reflect the costs involved in obtaining the necessary materials,
arranging specific equipment setups, filling out the required papers, appropriately
charging time and materials, and moving out the previous stock of materials, in making
each different product. If there were no costs or loss of time associated in changing
from one product to another, many small lots would be produced, permitting reduction in
inventory levels and the resultant savings in costs.

Inventory Costs 51
4.3.4 Shortage or stock-out costs or Under Stocking Costs
When the stock of an item is depleted, an order for that item must either wait until Notes
the stock is replenished or be canceled. There is a trade-off between carrying stock to
satisfy demand and the costs resulting from stock out. The costs that are incurred as
result of running out of stock are known as stock-out or shortage costs. As a result of
shortages, production as well as capacity can be lost, sales of goods may be lost, and
finally customers can be lost. This includes the loss in revenue due to drop in
production caused by non-availability of the materials. It is a notional cost.
In manufacturing, inventory requirements are primarily derived from dependent
demand. However, in retailing, the requirements are basically dependent on
independent demand. Inventory systems are predicated on whether demand is derived
from an end item or is related to the item itself. Because independent demand is
uncertain, extra inventory needs to be carried to reduce the risk of stocking out. To
determine the quantities of independent item that must be produced, firms usually use a
variety of techniques, including customer surveys, and forecasting. However, a balance
is sometimes difficult to obtain, because it may not be possible to estimate lost profits,
the effects of lost customers, or lateness penalties.
If the unfulfilled demand for the items can be satisfied at a later date (back order
case), in this case, costs of back orders are assumed to vary directly with the shortage
quantity (in rupee value) and the cost involved in the additional time required to fulfill the
backorder (Rs./Rs./year). However, if the unfulfilled demand is lost, the cost of
shortages is assumed to vary directly with the shortage quantity (Rs. /unit shortage).
Frequently, the assumed shortage cost is little more than a guess, although it is usually
possible to specify a range of such costs.
4.3.5 Overstocking cost

Overstocking costs are different from inventory carrying costs. In a situation where one
invests substantial amounts of money on stock that is either not found required or
becomes excessive or useless, then in such situations we incur a higher expenditure on
inventory due to overstocking the same. Carrying cost is said to be incurred when the
item is finally used, but when it is not used, it becomes overstocking cost. Overstocking
cost is the sum of item cost, ordering cost and the cost of carrying till the current time.
If we carry any inventory we are blocking money which in turn affects us by way of
blockage of funds. These funds carry interest and we have studied this as contributing
to Inventory Carrying Costs. However, in a situation where one is investing substantial
amount in inventory which is either found not required or becomes excessive or
useless, then in such situations we incur a higher expenditure on inventory for the
reasons of overstocking it. We could have used these funds for other profitable
ventures. An opportunity is therefore lost of utilising company’s valuable funds
productively. Overstocking cost is therefore a cost basically arising due to opportunity
lost due to the investment in unnecessary inventory. In situations when items are
ultimately used this can be treated as carrying cost. In situations where item cannot be
used, this cost is the sum of item cost, the cost of ordering and the cost of carrying till
the current time.
Understocking and overstocking more often arise in respect of items like spare
parts and consumables whose requirements are not deterministic and regular, but
probabilistic in terms of quantity required and time of requirement. In practice, to satisfy
all demands all the time, the quantity to be stocked will be very high and eventually
result in huge surpluses. It will be prudent to limit the quantity stocked to an optimum
level which would be balancing under stocking and overstocking costs. This is achieved
by using the concept of Service Levels.

4.3.6 Total Acquisition cost
Notes In this concept, the off-the-shelf price of an item alone is not taken into consideration
while deciding on procurement, but the total costs involved in consuming the item are
considered. Let us see below how this is done.
In the era of control regime, the task of purchasing and selling was relatively easy
and the market was assured. But suddenly all that changed – the markets opened and
competition increased. Selling is now possible only if prices are reduced and quality
improved. In other words, the customer wants more and more per unit cost.
To minimise the total production costs, it is recognised that one way is to tighten the
suppliers; another time-tested method is to reduce the cost of inputs. While it would be
desirable to reduce the cost of their supplies to us, the importance of building a
relationship with our suppliers has been recognised. Establishing a long-term
relationship is possible only when the supplier and purchaser jointly decide to reduce
the life cycle cost of an item by proper procurement, in such a way that it would lead to
a win-win situation to both the parties – in other words, suppliers become “Partners in
Progress”.
The purchaser cannot squeeze the supplier endlessly. Sourcing the right item from
the right vendors, getting it to the purchaser’s premises in the right way at the right price
and at the right time can alone optimise costs for the purchaser. This is possible only if
there is mutual trust, which develops into long-term relationships.
The major cost involved as we trace the path of a product from its raw material
stage till it is consumed in our process is called the life cycle cost of an item. The
purchase bill can be lowered if the total life cycle cost is optimum. In other words, the
total cost of acquisition and ownership of the item must be optimum.
4.4 Inventory Metrics

Managing inventory at manufacturing and service companies is critically important. Too
much or too little, or the wrong inventory, all have detrimental impacts on operational
and financial results as inventory represents a large capital investment. It also is an idle
resource. Companies that can operate with lesser inventory are considered to operate
more efficiently.
In general, supply chain inventories have been declining significantly in all parts of
the world. There are many factors that determine the level of inventory in an
organization, the most common factors on which the levels of inventory depend are the
following:
z Production Rate: The production rate can be defined as number of units
manufactured over a period of time.
Production Rate = No. of Units Manufactured/ time.
The time can be measured in days, weeks, or on an annual basis. Production rate
is also influenced by the demand for the product, which could be either periodic
(seasonal/cyclic) or a constant.
z Lead-time: Lead-time is defined as time period from initiating of an activity to its
completion. For inventory management, we need following lead times: Purchase
lead-time, manufacturing lead-time, Delivery lead-time.
z Rework/ Scrap Rate: This rate is dictated by the efficiency of the manufacturing
process. It involves knowing the number of defective units that are produced by a
manufacturing unit. This is highly an empirical rate and very much depends upon
the skill of the labour operating the machine and the accuracy offered by the
machine.
Inventory measures reflect, in part, the success in structuring systems to
optimize the production rate, the lead time and the scrap rate. Several aggregate

Inventory Costs 53
performance measures can be used to judge how well a company is able to control
these factors and utilizing its inventory resources.
z Average Inventory Investment: The rupee value of a company’s average level of
Notes
inventory is one of the most common measures of inventory. The information is
easily available and it is easy to interpret. It represents the average investment of
the company. However, it does not take into account the differences between
companies. For example, a larger company will generally have more inventory than
a smaller company, though it could be using its inventory more efficiently. This
makes it difficult for the company to make comparisons with other companies.
z Inventory Turnover Ratio: In order to overcome this problem, inventory turnover
ratio is used. This measure allows for better comparison among companies. This is
calculated as a ratio of company’s sales to its average inventory investment:
Inventory turnover = annual cost of goods sold/average inventory investment
This is a measure of how many times during a year the inventory turns around.
Because it is a relative measure, companies of different sizes can be more easily
compared. A higher turnover ratio reflects that there are less idle resources in the
company and therefore the company is using its inventory more efficiently. This
ratio can only be used in this manner to compare companies that are similar. For
example, even in the same industry depending on the distribution channels, a
retailer would have a much lower inventory turnover ratio than the wholesaler or
distributor.
z Days of Inventory: A measure that tries to overcome the disadvantage, to a limited
degree, and is closely related to inventory turnover is ‘days of inventory’. This
measure is an indication of approximately how many days of sales can be supplied
solely from inventory. The lower this value, the more efficiently inventory is being
used if customer demands are being met in full. There are two ways of calculating
‘days of inventory’, it can be directly calculated or inventory turnover can be
converted to days of inventory. Both procedures are shown below:
Days of inventory = avg. inventory investment/annual cost of goods sold/days per
year
Days of inventory = days per year/ inventory turnover rate
As an example of these measures, assume a firm has an annual cost of sales of
Rs.18 crore and an average inventory level for the year of Rs. 2 crore, then:
Inventory Turnover Ratio = annual cost of goods sold/average inventory
investment
= Rs18 crore/Rs. 2 crores = 9 turns
The cost of sales for a day is Rs. 18 crore/360 days = Rs. 5 lacs
Days of Inventory = avg. inventory investment/ annual cost of goods sold/days
per year
= Rs. 2 crore/ Rs. 5 lacs = 40 days inventory
Detailed measures of inventory accuracy and availability are very important in order
to maximize manufacturing and non-manufacturing efficiency and financial results.
In addition to the measures described above, inventory obsolescence measures
can be very important for items with short shelf lives, due to aging or technological
changes.
Finally, collecting accurate data on which to construct inventory measures can be
challenging. Processes have to be in place to ensure that inventory is counted
accurately and on a timely basis.
In general, supply chain inventories have been declining significantly in all parts of
the world. In 1970, U.S. manufacturers held more than 50 percent of aggregate
inventory stocks, but this share had fallen to about 35 percent in 2000. By sector, the
manufacturing share of durable goods inventories has declined from 60 percent in the
Notes late 1960s to about 40 percent by the end of 2000; for non-durable goods, the
manufacturing share has decreased from 40 percent to about 25 percent over the same
period.
This trend is true for all inventory types, be it retail or manufacturing. Companies
today must be fast and nimble enough to react quickly to changes in customer demand
and do it with little inventory to remain competitive in the market.
The challenge for retailers, in reducing inventories, is due to the high value added
content of the inventory because they hold finished products. A significant cost to retail
organisations is the inventory carried to support customers and sales. Companies have
to reduce these costs to maintain competitive advantage and bottom-line benefits.
The challenge of manufacturers is due to the diversity of their inventory holdings
which cumulatively add up to a very high capital commitment for the organisation.
Effectively managing and minimizing investments in inventory can certainly help the
organisation to manage its manufacturing processes and reduce its costs to stay ahead
of competition.
4.5 ABC (Activity Based Costing)

With the advent of logistics management and supply chain management, the scope of
materials management and in turn inventory management encompasses finished goods
also. In the costing/pricing of Finished Goods which are the end products of the
company, traditionally three types of costs have been considered, direct costs, indirect
costs and overheads. Traditional accounting systems in manufacturing firms allocate
factory/corporate overhead to products based on direct labour. In the past, this method
of allocation may have resulted in minor distortions. However, product lines and
channels have proliferated and overhead costs have increased dramatically, making
traditional allocation methods dangerously inaccurate.
An activity based system examines the demands made by particular products (or
customers) on indirect resources. Three rules should be followed when examining the
demands made by individual products on indirect resources:
(a) Focus on expensive resources.
(b) Emphasize resources whose consumption varies significantly by product and
product type.
(c) Focus on resources whose demands are uncorrelated with traditional allocation
methods such as direct labour or material costs.
The process of tracing costs, first from resources to activities that “drive” resource
usage (cost drivers) and then from activities to specific products (or customers), cannot
be done with surgical precision.
Activity based costing has been found particularly in planning, administering and
control of warehousing activities. Traditional costing systems, in place, in many firms,
often do not provide financial data in the proper form for use in making warehousing
decisions. Frequently, it is difficult to identify how warehousing costs impact overall
corporate profitability and how changes in costs in one area affect costs in another.
Some companies are implementing ABC in order to have better warehousing cost
information.

Inventory Costs 55
Proponents of ABC state that it unbundles traditional cost accounts and shows how
resources are consumed. The following figure compares the two approaches:
Notes
General Ledger View of Activity Based View of Warehousing Costs
Warehousing Costs
Storage and $40.1 Dry storage $25.0
Handling
General & 30.9 Refrigerated Storage 8.1
Administration
Trucking and 14.5 Receiving 20.0
Delivery
Freight 2.4 Shipping 18.8
Consolidation
Value-added 3.3 Billing 3.2
services
Delivery 6.0
Packaging/Stenciling 1.8
Freight consolidation 3.0
Material handling 5.3
equipment
Total $91.2 Total $91.2
As we all know, while costing/pricing the finished goods of a company, three types
of costs are considered – direct costs, indirect costs and overheads. As per traditional
accounting systems, manufacturing firms allocate the factory overheads to products
based on direct labour. By dividing the total estimated overhead costs by the total
estimated direct labour hours, an overhead rate can be established. This sometimes
results in minor distortions, especially in situations where there are several product lines
and several processes. Also, direct labour costs have shrunk to 10% of the total costs
due to the introduction of advanced manufacturing technology and other improvements
in productivity. Hence, it has become a less logical and realistic basis on which to
allocate indirect costs.
It was, therefore, felt that the costing should be based on the demands made by
particular products on indirect resources and should especially take into account those
resources which are expensive or whose consumption varies significantly with the
product type. Causal factors, known as cost drivers are identified and used as a means
of allocating overhead. These factors might include machine hours, computer time,
miles driven, etc. The accuracy of overhead allocation depends on the selection of
appropriate cost drivers. Attention should also be paid to resources whose demands
have no relation with traditional allocation methods, such as direct labour or material
costs.
During the 1980s, a team of academics led by Prof. Robert Kaplan and Prof. Robin
Cooper of Harvard Business School developed the concept of Activity-based Costing.
This concept has now evolved into Activity-based Management (ABM). This involves a
two-stage allocation process. In the first stage, overhead costs are assigned to cost
activity pools. These pools represent activities such as performing machine setups,
issuing purchase orders and inspecting parts. In the second stage, costs are assigned
from these pools to activities based on the number or amount of pool related activity
required in the completion.

Representing this pictorially: Activity Based Costing

Traditional Costing
Notes
Total overhead
Total overhead
Pooled based
Labour hour allocation on activities
End product cost Cost pools
Cost driven
Allocation
End product costs
Figure 4.1: Activity Based Management (ABM)

Activity based costing has been found particularly useful in the area of warehousing
activities, where there are multiple activities and traditional accounting systems fail
when it comes to identifying the impact of these activities on the overall profitability of
the company.
The example below illustrates the same:
Traditional Method of Activity Based Costing
Costing (` lakhs)
Storage and Handling 40 Dry Storage 25

Administration expenses 31 Refrigerated storage 8
Trucking & Delivery 15 Receiving 20
Freight consolidation 2 Shipping 19
Value added Services 3 Billing 3
Delivery 6
Packing/stenciling 3
Freight consolidation 2
Material handling eqpt. 5
91 Total 91
Thus, we see that the ABC/ABM method unbundles traditional cost accounts and
shows how resources are consumed.
ABM can be used to identify opportunities to reduce the supplier’s indirect costs. It
goes beyond identifying and allocating these indirect costs to products – it identifies the
drivers of these costs. These drivers may include – number of orders, length of setups,
specifications, engineering changes, supplier meetings, etc. This traceability and
identification of costs helps the management to identify cost saving opportunities. Due
to all these reasons, Activity Based Costing is also sometimes referred to as
Transaction Costing.
4.5.1 Limitations of ABC

It is better to be mostly correct with activity-based costing – say, within 5 to 10
percent of the actual demands a product or customer makes on an organisational
resources – than to be precisely wrong (perhaps by as much as 200 percent) using
outdated techniques or including indirect common costs.

Inventory Costs 57
It should be noted that whenever costs are allocated, we are admitting that we
cannot identify the cause of the cost – on an avoidable cost basis. If this information
were available, we could attach (assign) the cost to the appropriate segment. Notes
4.6 Summary
Inventory is a cost. This means there are several costs associated with holding
inventories. Besides the cost of the material themselves, there are two basic categories
of costs associated with inventories. They are: Inventory carrying costs: It includes all
the costs that are associated with holding an inventory. When inventory is stored, we
are actually storing company's money, which attracts a huge interest rate. It comprises
of five major cost elements. Inventory acquisition costs: During the 1980s, a team of
academics led by Prof. Robert Kaplan and Prof. Robin Cooper of Harvard Business
School developed the concept of Activity based Costing. This concept has now evolved
into Activity based Management (ABM). This involves a two-stage allocation process.
The heart of inventory decisions lies in the identification of inventory costs and
optimising the costs relative to the operations of the organisation. It costs money to hold
inventory. Such costs are called inventory holding costs or carrying costs. This broad
category includes the costs for storage facilities, handling, insurance, pilferage,
breakage, obsolescence, depreciation, taxes, and the opportunity cost of capital.
There are costs incurred in maintaining and updating the information system,
developing vendors, evaluating capabilities of vendors. Ordering costs also include all
the details, such as counting items and calculating order quantities. Set-up costs reflect
the costs involved in obtaining the necessary materials, arranging specific equipment
setups, filling out the required papers, appropriately charging time and materials, and
moving out the previous stock of materials, in making each different product. When the
stock of an item is depleted, an order for that item must either wait until the stock is
replenished or be canceled. There is a trade-off between carrying stock to satisfy
demand and the costs resulting from stock out.
Carrying cost is said to be incurred when the item is finally used, but when it is not
used, it becomes overstocking cost. Overstocking cost is the sum of item cost, ordering
cost and the cost of carrying till the current time. In general, supply chain inventories
have been declining significantly in all parts of the world. There are many factors that
determine the level of inventory in an organization.
Activity based costing has been found particularly in planning, administering and control
of warehousing activities. Traditional costing systems, in place, in many firms, often do
not provide financial data in the proper form for use in making warehousing decisions.

1. An analysis of inventory is useful to determine the ________ of stocks.
(a) Base
(b) level
(c) Control
(d) Type
2. Large _______________ of inventory also cause long cycle times which may not be
desirable as well.
(a) Holdings
(b) Stocks
(c) Both (a) and (b)
(d) None of these

3. There is a _____________________between fixed and variable costs of holding

inventory.
Notes (a) Equality
(b) Understanding
(c) Uniqueness
(d) Differentiation
4. The income which the company foregoes on account of blocking the money in
inventory is called the ________________associated with inventory investment. (a)
‘Opportunity cost’
(b) Inventory Cost
(c) Holding Cost
(d) Ordering Cost
5. More the inventory more is the cost of ________ the material.
(a) Coding
(b) Controlling
(c) Verifying
(d) Storing
6. Although it costs money to hold inventory, it also, unfortunately, costs to
____________inventory.
(a) Storing
(b) Replenish
(c) Differentiating
(d) Leveling
7. _________________ cost is the sum of item cost, ordering cost and the cost of
carrying till the current time.
(a) Overstocking
(b) Understocking
(c) Insurance
(d) Opportunity
8. ______________ is defined as time period from initiating of an activity to its
completion.
(a) Lead-time
(b) Days of Inventory
(c) Order time
(d) Over time
9. The purchase bill can be lowered if the total life cycle cost is ___________.
(a) Optimum
(b) Less
(C) more
(d) Unbalanced
10. __________ can be used to identify opportunities to reduce the supplier’s indirect
costs
(a) SOS
(b) HML
(c) VED

Inventory Costs 59
(d) ABM
4.8 Questions and Exercises Notes

(a) Activity based Costing
(b) Understocking Cost
(c) Overstocking Cost
(d) Acquisition Cost
(e) Inventory Carrying Cost
2. Distinguish between inventory carrying cost and ordering cost.
3. Explain in detail the elements of Inventory Carrying Cost and Ordering Cost.
4. A company has a monthly demand for an item as 800 units. The procurement cost
is ` 50 per order and inventory carrying cost is ` 0.80 per unit per year. Compute
the economic lot size and number of orders per year.
5. Discuss the effects of overstocking and under stocking in an organisation.
6. What are the most common factors on which the levels of inventory depend?
7. Discuss the relevance of Activity Based Costing in inventory management.
8. Write a note on days of inventory.
4.9 Key Terms

z Activity Based Costing: An Activity based costing system examines the demands
made by particular products or customers on indirect resources.
z Understocking Cost: Understocking costs occur due to not carrying an inventory
at all or carrying fewer inventories than required. This includes the loss in revenue
due to drop in production caused by non-availability of the materials. It is a notional
cost.
z Overstocking Cost: Overstocking cost is the sum of item cost, ordering cost and
the cost of carrying till the current time.
z Acquisition Cost: The cost that a company identifies on its books of inventory after
adjusting for discounts, incentives, closing costs and other necessary expenditures,
but before sales taxes.
z Inventory Carrying Cost: It includes all the costs that are associated with holding
an inventory. When inventory is stored, we are actually storing company's money,
which attracts a huge interest rate. It comprises of five major elements.

1. (b) level
2. (a) holdings
3. (b) Differentiation
4. (a) ‘Opportunity cost’
5. (d) storing
6. (b) replenish
7. (a) Overstocking
8. (a) Lead-time
9. (a) Optimum
10. (d) ABM


Notes z Gopalakrishnan P, Handbook of Materials Management, Prentice Hall of India
New Delhi
CASE STUDY
M/s Indiana Steels has four steel plants at various locations in India. Each steel plant
uses rolls to the extent of about Rs 20 crores/year, against a sales turnover of Rs 1200
crores/year.
Mr Chintamani took over as Vice President to look after procurement. He began
questioning the manner of procurement and usage of rolls and noticed the following –
z A roll failure occurs every week in some plant or the other.
z It takes 8 hours to remount a roll.
z Loss due to this downtime is approximately Rs 50000/hour.
z Most common reasons for roll failure recorded are – cracks, ends getting worn out
faster, improper grinding, improper mounting, etc. But till date no supplier has ever
paid any penalty for poor performance of rolls supplied.
z Suppliers are common across the four plants.
z All the suppliers are indigenous.
z Roll types are more than 60% common across the plants.
z The exercise of procurement takes over 90 days every year in each plant.
z Roll specifications that were designed by the consultant while installing the rolls 15
years back is still being used for procurement.
Mr Chintamani began probing and asking:
z How are the rolls specified worldwide?
z What life do the imported rolls give compared to our rolls?
z What are the types of rolls being used worldwide?
z What are the roll usage practices worldwide?
z Why has no order been placed from any foreign source during the last five years?
Mr Chintamani found out the following:
z Our plants are still using Cast Iron (CI) rolls, whereas, plants worldwide have
progressed to Alloy Chilled (AC) Rolls. They cost 8-10% more than CI rolls but their
performance is 40-50% higher.
z Rolls are a capital intensive industry. There are few but very big players. They have
formed a cartel. ISS requirement is less than 10% of their requirement. They all
make AC Rolls.
z Our specifications are antiquated. World over, rolls are being purchased by
indicating the tonnage that is expected out of a roll. Bonus and penalty for higher
and lower performances respectively are defined.
Question:
Mr Chintamani is going to completely revamp the system of procurement of rolls.
Any suggestions?

Inventory Replenishment 61
Unit 5: Inventory Replenishment

Notes
Structure
5.1 Introduction
5.2 Economic Order Quantity
5.2.1 Determination of EOQ by calculation
5.2.2 Strengths and Limitations of the EOQ concept
5.2.3 EOQ and Quantity Discount
5.3 When to Order
5.4 Inventory Models
5.4.1 A Single Period Inventory Model
5.4.2 Multi-period Inventory Models
5.4.3 Comparison between P and Q models
5.5 Functions of Safety Stock
5.6 Summary
5.9 Key Terms
Objectives
z Understand why EOQ is used in inventory replenishment
z Explain usefulness of safety stock
z Explain various inventory models
z Explain the time to place order for inventory
5.1 Introduction
Whenever one has to make decisions about managing an inventory, two basic
questions have to be asked:
z How much of each item must be stocked?
z When should an order be released and for what quantity?
Demand can be certain or uncertain. We will read more about demand in the
succeeding chapters. In a dynamic and certain situation where the demand is fully
known and the supplies can be had whenever required, we can again have two
situations:
z We can either have more number of orders and cause an increase in ordering cost,
z We can have large supplies with few orders and carry more inventories, thus
incurring high inventory carrying costs.
Both of these situations are not desirable. We have therefore to strike a balance
between the two and order that quantity each time wherein both the costs are optimum
and therefore the total cost is minimum.

5.2 Economic Order Quantity

Notes That quantity which when ordered and delivered results in the total costs being
minimum is called the ECONOMIC ORDER QUANTITY (EOQ). In this situation, the
Ordering Cost is equal to the Inventory Carrying Cost.
The question now: arises how to determine EOQ? Let us do it by a Trial and Error
Method.
Example1.
Suppose an item has an annual consumption of 10,000 units, price of the unit is Rs 1/-,
inventory carrying cost is 30% per annum and ordering cost is Rs 60/- per order.
If we place only one order in a year, the ordering cost will be Rs 60/- but inventory
carrying cost will be:
10000 × 1 × 30
= 1500
2 × 100
(Average inventory for an order of 10000 units is 10000/2)
Total cost = 1500 + 60 = 1560/-
We can do a similar calculation for different order quantities and tabulate the results
below:
Sl No. Quantity per No. of orders Ordering cost Inventory Carrying Total Cost
order Cost
1 10000 1 60 × 1=60 10000 × 1 × 30 =1500 1560
2 × 100
2 5000 2 60 × 2=120 5000 × 1 × 30 =750 870
2 × 100
3 4000 2.5 60 × 2.5=150 4000 × 1 × 30 =600 750
2 × 100
4 2000 5 60 × 5=300 2000 × 1 × 30 =300 600
2 × 100
5 1000 10 60 × 10=600 1000 × 1 × 30 =150 750
2 × 100
6 500 20 60 × 20=1200 500 × 1 × 30 =75 1275
2 × 100
From the above table we observe that the total cost is minimum when the ordering
quantity is 4000 units. Below it as well as above it, the total cost increases. Also, when
the total cost is minimum, the ordering cost is equal to the inventory carrying cost.
5.2.1 Determination of EOQ by calculation
Annual Demand
No. of Orders =
Quantity per Order
Total Ordering Cost = Cost of ordering × No. of Orders
Average Inventory = (Quantity per Order)/2
Cost of Carrying Inventory = Average inv. × Unit cost × inventory Carrying cost
Total Cost = Ordering cost + Inventory Carrying cost
Representing the same arithmetically:
If A = annual consumption in units

C = Unit Cost
U = Cost/order Notes
I = Inventory carrying cost as a percentage of average inventory
Q = Quantity to be ordered per order
Then,
No. of orders = A/Q
A
Ordering Cost = U×
Q
Average inventory= Q/2
Q×C× I
Carrying cost =
2
At EOQ conditions, the ordering cost is equal to the inventory carrying cost.
A Q×C× I
U× =
Q 2
Or, Q² × C × I = 2A × U
2A × U
Or, Q 2 =
C× I
2A × U
Or, Q =
C× I
Substituting the figures of the earlier example,
2 × 10000 × 60
EOQ = = 2000
1 × 0.30
5.2.2 Strengths and Limitations of the EOQ concept

EOQ is a very simple yet powerful tool to calculate various lot sizes in ideal situations. It
can be modified to accommodate numerous special conditions. Prof. Daniel Jones, a
mathematician who has researched various lot sizing concepts says that EOQ can be
used in conjunction with various inventory management systems including JIT. When
properly used, there is little difference between lot sizes based on the JIT and EOQ
models.
It however has its limitations. The EOQ concept is based on the fact that material
prices and transportation costs are constant for the order quantities considered and the
period considered. But this is not often true. Volume discounts, price increases and
freight rate increases often vary the price. The demand for the item may also change.
But it is possible to include these variables in the formula for EOQ. By comparing the
annual material cost savings resulting from purchase of additional quantity with
additional inventory carrying costs resulting from the increased purchase, the EOQ can
be calculated.
The EOQ concept is also based on the fact that ordering costs and inventory
carrying costs are calculated accurately. This is often not so. EOQ calculated is often
an inconvenient number, or orders could happen at odd points of time. EOQ fails when
the goods in question are seasonal goods.

With modifications, the EOQ concept can also be used in the determination of
economic production lot sizes in a manufacturing operation. In this case, the ordering
Notes cost will be replaced by the setup cost.
This can also be used in banks and financial institutions to calculate the daily
currency requirements. In this case, the ordering cost will be the money spent on
collection and other related expenditure. The carrying cost will be interest charges and
amount spent on safeguarding the money.
5.2.3 EOQ and Quantity Discount

Let us take a situation where a supplier gives a quantity discount for ordering quantities
more than the EOQ. If we avail this discount, we will get a lower ordering cost since the
number of orders will now be less. But carrying cost will be more since inventory will be
more. The discount can only be availed if the new (discounted) costs are less than the
EOQ total cost i.e.
Savings in discounts + savings in ordering cost > Loss due to extra inv carrying cost
Let us show this by an example.
Example 2.
Suppose, A = 5000
U = Rs 100/order
I = 30% per annum
C = Rs 50/unit
2A × U
Or, EOQ =
C×I
2 × 5000 × 100
Or, EOQ = = 258 units
50 × 0.30
No. of orders per annum = 5000/258 = 19.38 say 19
Suppose the supplier gives a discount of 5% if order quantity is 1000 units.
The saving in ordering cost will be:
{5000/258 – 5000/1000} × 100 = Rs 1400/-
Saving on account of price discount = 5000 × 50 × 5/100 = Rs 12500/-
Total saving on account of ordering increased qty = 1400 + 12500 = Rs 13900
(1000 − 258) × 50 × 30
Loss due to carrying additional inventory – = Rs.5565
2 × 100
Since there is a net saving on account of ordering increased quantity, we may go

for the discount offered.
5.3 When to Order

The reorder point is:
R= DL + zs
Where R = Reorder point in units
D= Average daily demand (Average Annual Demand/365)

L= Lead time in days, between placing an order and receiving the items
z= No. of standard deviations for a specified service probability. Once the desired Notes
service probability is given, the z value can be either calculated by
statistical methods or obtained from statistical tables.
s = Standard deviation of usage during lead time
There are a number of statistical formulae adopted to determine the safety stock
level of individual items based on variations in the trend of demand and consumption,
degree of reliability placed on supplier’s delivery schedules and the service level
desired. These are based on studies of variations in demand from month to month,
week to week over a long period. When rearranged in terms of the lowest to the highest
values, they reveal some characteristic patterns of frequency distribution. These well-
known distribution patterns are classified according to the behaviour, into ‘Normal’,
‘Poisson’, ‘Exponential’ etc. which are influenced by the relation between the highest
and lowest values and their proximity to the average value. Suitable formulae can be
prescribed for each of these frequency distributions for calculating likely variations in
future demands.
As we have already seen, variations in future demand are not the only cause for
stock out. The variations in lead time usages and related uncertainties in delivery time
must also be taken into consideration which makes these formulae and their
calculations very complicated. It involves numerous repeated tests of the combined
effect of variations in demand, in lead time usages, in anticipated delay in delivery
schedules etc., to arrive at an ideal safety stock level. Various computer packages are
nowadays available which make this task much easier.
Let us assume that the consumption pattern of an item follows a normal distribution.
The average consumption would be midway between the maximum and minimum
levels. The number of times consumption exceeds the maximum levels would be the
same number of times it falls below the minimum levels. Here the concept of Standard
Deviation “s” can be used.
Safety stock equivalent to one s held over and above the average consumption will
cover usage fluctuations upto 34% above normal. Since the average stockholding
implies 50% coverage, the assurance level with stock level at one s over and above the
average will be 84%. Similarly, provision for safety stocks at 1.5, 2.0 and 3.0 s above
the average usage will give approximately 93.33%, 97.667%, and 99.999%
respectively.
We have learnt in the previous paragraph that in normal distribution, consumption is
assumed to follow a normal pattern and the average consumption was midway between
the maximum and minimum levels. But in reality, the average consumption may not fall
midway between the minimum and maximum, but nearer to the minimum and occasions
when demand exceeds the average consumption are inherent. A few of the demands
may far exceed the average consumption. Poisson’s distribution relates to chance
events where the probability of its occurrence is low but its value may be large. It is
generally applied to the occurrence of failures of parts of equipments. The Poisson’s
curve is applicable to small numbers and as the average consumption gets larger and
larger, the shape of the curve begins to resemble the normal distribution curve.
Poisson’s distribution curve should only be applicable when the mean is not a large
number. Control Tables are available in every industry from which the safety stocks are
calculated based on the Accepted Average number of years.
Example 3
Let the monthly usage of an item in numbers for 12 months of a year be as follows:
80, 50, 110, 200, 110, 130, 90, 100, 110, 160, 70, 110
The average or mean usage is = 110

Deviations of the monthly usage from the mean are:
Notes -30, -60, 0, 90, 0, 20, -20, -10, 0, 50, -40, 0

Squares of these deviations are:
900, 3600, 0, 8100, 0, 400, 400, 100, 0, 2500, 1600, 0
Mean of the sum of the squares = 1466.67
Standard Deviation
Safety stock for 1 s = 38 units
Service level = 84%
Safety stock for 2 s = 76
Service level = 97.667%
Safety stock for 3 s = 114
Service level = 99.99% and so on
This is to be interpreted thus – Suppose it takes ` 1 lakh to provide Safety Stock to
meet the demand fluctuations upto one s above the average consumption, i.e. providing
84% service level, it will then cost ` 2 lakh and ` 3 lakh to provide service levels of
97.667% and 99.999% respectively. Additional installments in safety stocks do not give
proportionate protection from stock outs or service levels.
There could be four situations arising out of variation in two parameters –
Consumption rate and Lead time.
Based on this, we decide when an order is to be placed for an item. By the same
logic, there are two parameters that decide when an order is to be placed. They are:
z Quantity
z Interval between orders.
A combination of these two parameters could lead to four situations:
1. Both Quantity and Interval between orders are fixed.
2. Order Quantity is fixed but Interval between orders is variable.
3. Order Quantity is variable but Interval between orders is fixed.
4. Both orders Quantity and Interval between orders are variable.
5.4 Inventory Models

An inventory system provides the organizational structure and the operating policies for
maintaining and controlling goods to be stocked. The system is responsible for ordering
and receipt of goods: timing the order placement and keeping track of what has been
ordered, how much, and from whom. The particular classification is based on whether
the decision is just a one-time purchasing decision where the purchase is designed to
cover a fixed period of time and the item will not be reordered, or the decision involves
an item that will be purchased periodically where inventory should be kept in stock to be
used on demand .This section divides system in two parts:
1. Single period inventory model
2. Multi period inventory model
5.4.1 A Single Period Inventory Model

In a single-period model, the item unsold at the end of the period is not carried over to
the next period. The unsold items, however, may have some salvage values. Examples
of single period inventory model are Computer that will be obsolete before the next

order, perishable product, seasonal products such as bathing suits, winter coats, etc.
Newspaper and magazines are also the examples of single period inventory model.
Notes
Trade-offs in Single-Period Models
Loss resulting from the items unsold
ML= Purchase price - Salvage value
Profit resulting from the items sold
MP= Selling price - Purchase price
Trade-off
Given costs of overestimating/underestimating demand and the probabilities of various
demand sizes how many units will be ordered?
Consider an order quantity Q
Let P = probability of selling all the Q units
= probability (demand Q)
Then, (1-P) = probability of not selling all the Q units, we continue to increase the
order size so long as
P(MP) ≥ (1 – P)ML
ML
or P ≥
MP + ML
Decision Rule: Order maximum quantity Q such that
ML
P ≥
MP + ML
Where P = probability (demand ≥ Q)
Example 4
Demand for cookies:
Demand Probability of Demand
1,800 dozen 0.05
2,000 0.10
2,200 0.20
2,400 0.30
2,600 0.20
2,800 0.10
3,000 0.05
Selling price=$0.69, cost=$0.49, salvage value=$0.29
(a) Construct a table showing the profits or losses for each possible quantity
(b) What is the optimal number of cookies to make?
(c) Solve the problem by marginal analysis.

Demand Prob Prob Expected Revenue Revenue Total Cost Profit

(dozen) (Demand) (Selling Number from from Revenue
Notes all the Sold Sold Unsold
units) Items Items
1800 0.05
2000 0.1
2200 0.2
2400 0.3
2600 0.2
2800 0.1
3000 0.05
Sample computation for order quantity = 2200:

Expected number sold = 1800 (0.05) + 2000(0.10) + 2200(0.85) = 2160
Revenue from sold items = 2160(0.69) = $1490.4
Revenue from unsold items = (2200 – 2160)(0.29) = $11.6
Total revenue = 1490.4 + 11.6 = $1502
Cost = 2200(0.49) = $1078
Profit = 1502-1078 = $424
Demand Prob Prob Expected Revenue Revenue Total Cost Profit

(dozen) (Demand) (Selling Number From From Revenue
all the units) Sold Sold Unsold
Items Items
1800 0.05 1 1800 1242.0 0.0 1242 882 360
2000 0.1 0.95 1990 1373.1 2.9 1376 980 396
2200 0.2 0.85 2160 1490.4 11.6 1502 1078 424
2400 0.3 0.65 2290 1580.1 31.9 1612 1176 436
2600 0.2 0.35 2360 1628.4 69.6 1698 1274 424
2800 0.1 0.15 2390 1649.1 118.9 1768 1372 396
3000 0.05 0.05 2400 1656.0 174.0 1830 1470 360
Solution by marginal analysis:
MP = .69 – .49 = $0.20, ML = .49 – .29 = $0.20
Order maximum quantity, Q such that
ML 0.20
P = Pr obabilit (demand ≥ Q) ≥ = = 0.50
MP + ML 0.20 + 0.20
Demand, Q Probability (demand) Probability (demand Q), p
5.4.2 Multi-period Inventory Models

There are two general types of multi period inventory systems:
1. Fixed order quantity models
2. Fixed time period models
Multi period inventory systems are designed to ensure that an item will be available
on an ongoing basis throughout the year. Usually the item will be ordered multiple times
throughout the year where the logic in the system dictates the actual quantity ordered
and the timing of the order. The fixed order quantity model is also called as economic

order quantity, EOQ and Q- model. Whereas fixed time period models is also called as
periodic system, periodic review system, fixed- order interval system, and P-model.
Notes
The basic distinction is that fixed-order quantity models are "event triggered" and
fixed time period models are "time triggered." That is, a fixed-order quantity model tells
about an order when the event of reaching a specified reorder level occurs. This event
may take place at any time, depending on the demand for the items considered.
In contrast, the fixed-time period model is limited to placing orders at the end of a
predetermined time period; only the passage of time triggers the model. Some
differences tend to affects the choice of systems:
1. The fixed-time period model has a larger average inventory because it must also
protect against stock out during the review period, T; the fixed-order quantity model
has no review period.
2. The fixed-order quantity model favors more expensive items because average
inventory is lower.
3. The fixed-order quantity model is more appropriate for important items such as
critical repair parts because there is closer monitoring and therefore quicker
response to potential stock out.
A Fixed Order Quantity Model

Purchase-order can be placed at any time. On-hand inventory count is known
always. Fixed-order quantity models attempt to determine the specific point, R, at which
an order will be placed and the size of that order, Q. The order point, R, is always a
specified number of units. An order of size Q is placed when the inventory available
(currently in stock and on order) reaches the point R. Lead time for a high speed
modem is two weeks and it has the following sales history in the last 25 weeks:
Quantity/Week Frequency
75-80 1
70-75 3
65-70 9
60-65 8
55-60 4
Will you order now if number of items on hand is:

(a) 200
(b) 150
(c) 100
The same quantity, Q is ordered when inventory on hand reaches a reorder point, R

(a) An order quantity of EOQ works well

(b) If demand is constant, reorder point is the same as the demand during the lead
Notes time.
(c) If demand is uncertain, reorder point is usually set above the expected demand
during the lead time.
Reorder point = Expected demand + Safety stock
Safety Stock
Safety stock for independent demand items protects against fluctuations in customer
demand. Safety stock calculations use statistics to mitigate the risk of stock out. A
service criteria measures risk as the probability of not stocking out during the order
cycle. Safety stock could be defined as the amount of inventory carried in addition to the
expected demand.
In constructing any inventory model, the first step is to develop a functional
relationship between the variables of interest and the measure of effectiveness. In this
case, because we are concerned with cost, the following equation pertains:
Total annual cost = Annual purchase cost + Annual ordering cost + Annual holding cost
For example, an objective may be something like "set the safety stock level so that
there will only be a 5 percent chance of stocking out if demand exceeds 300 units." We
call this approach to setting safety stock the probability approach.
Trade-off with Safety Stock

Safety Stock: Stock held in excess of expected demand to protect against stock out
during lead time.
Safety stock- Holding cost- Stock outs¯
Safety stock¯ Holding cost¯ Stock outs-
Acceptable Level of Stock out
Ask the manager!!
Acceptable level of stock out reflects management's tolerance
A related term is service level.
Example: if 20 orders are placed in a year and management can tolerate 1 stock out in
a year, acceptable level of stock out = 1/20 = 0.05 = 5% and the service level = 1– 0.05
= 0.95.
Fixed-Time Period Model

In a fixed-time period system, inventory is counted only at particular times, such as
every week or every month. Counting inventory and placing orders periodically are
desirable in situations such as when vendors make routine visits to customers and take
orders for their complete line of products, or when buyers want to combine orders to
save transportation costs. Other firms operate on a fixed time period to facilitate
planning their inventory count; for example, Distributor X calls every two weeks and
employees know that all Distributor X's product must be counted. This model generates
order quantities that vary from period to period, depending on the usage rates. These
generally require a higher level of safety stock than a fixed-order quantity system. The
fixed-order quantity system assumes continual tracking of inventory on hand, with an
order immediately placed when the reorder point is reached. In contrast, the standard
fixed-time period models assume that inventory is counted only at the time specified for
review.

Notes
Figure 6.1: Fixed Time Period Model

Replenishment Level and Safety Stock
Replenishment level, M = Desired inventory to cover review period & lead time =
Expected demand during review period & lead time + Safety stock order quantity,
Q=M-H
H = inventory on hand
Trade-off with safety stock
Safety stock- Holding cost- Stock outs¯
Safety stock¯ Holding cost¯ Stock outs-
Figure 6.2: Replenishment Level and Safety Stock
5.4.3 Comparison between P and Q models

Table 5.1: Comparison between P and Q models
Fixed Fixed Period

Quantity
Advantage Not large Ease of coordination,
safety stock, Less work, good for
good for inexpensive items
expensive
item.

Safety stock r − μL M − μT + L
Notes Average inventory, regular 1 1
Q μT
2 2
Order quantity 2DS M-I
EOQ=
H
Reorder point r = μ L + zσ L
Replenishment level M = μT + L + zσ T + L
Annual number of D 1
orders T is in years
Q T
5.5 Functions of Safety Stock

Like forecasting, effectively calculating your safety stock requirements can result in
getting greater performance out of fewer inventories. Unfortunately, most businesses do
a lousy job of calculating safety stock. Safety stock is used primarily to compensate for
demand variability that cannot otherwise be calculated as part of your forecast. This
seemingly random variability is called noise, and while we can’t predict
with certainty exactly when it will happen, we can estimate how frequently
certain levels of variability will occur. We can do this through the use of statistical tools.
We can then use this information to plan safety stock levels that will meet
our fill-rate requirements while minimizing our inventory investment the optimization
model leads to the determination of where to place decoupling inventories that protect
one part of the supply chain from another. In particular, a decoupling safety stock is an
inventory large enough to permit the downstream portion of the supply chain to operate
independently from the upstream, provided that the upstream portion replenishes the
external demand. In this sense, the determination of where to place these decoupling
points in a supply chain is a major design decision and is “strategic” in nature.
Furthermore, this terminology is consistent with that used in industry.
To meet the uncertainties arising from fluctuating demand, fluctuating lead times,
unforeseen situations etc. An extra stock is invariably maintained for each item in the
inventory. This extra stock is termed as buffer stock or safety stock. Safety stocks arise
due to variations in consumption rates and variations in lead times.
There are various factors that influence the determination of safety stock. They are:
1. Nature of the Item: Items that are tailor-made, i.e. needed for a particular
equipment or machinery, which are made based on drawings or specifications,
require a safety stock to be maintained to take care of the lead time required to
manufacture those items. Standard items, i.e. those available off the shelf, such as
motors, batteries, tyres etc. may not require a safety stock to be maintained as they
can be procured immediately. For the manufacture of the items, if the setup costs
are high (which is more relevant for tailor-made items), it would be more prudent to
store a larger quantity.
2. Annual Usage: Class A items having high consumption would be more prone to
fluctuations than B or C class items and require more safety stock.
3. Lead Time of Manufacture: Items having longer lead times for manufacture and/or
supply are more prone to fluctuations and therefore require a safety stock to be
maintained. E.g. imports, mechanical spares etc.
4. Stock out Cost: If the stock out cost of an item is high, i.e. non-availability of the
item would result in high loss of production, such items should have a considerable
safety stock.

5. Seasonality: For items which are manufactured only during a particular season, it
may be sensible to stock till the next season arrives. Even though the item may be
available throughout the year, the factor of price does come into play. Notes
6. Risk of Obsolescence/Deterioration: For items that have low shelf life e.g.
medicines, vulcanizing solution, certain electronic items, etc. it may not be prudent
to carry a large stock. A small safety stock would be sufficient.
7. Macro/Environmental Issues: Uncertainty in supplies due to circumstances such
as impending war, change in policies, government restrictions, etc. may cause a
larger safety stock to be maintained.
5.6 Summary
Demand can be certain or uncertain. We can have large supplies with few orders and
carry more inventories, thus incurring high inventory carrying costs. That quantity which
when ordered and delivered results in the total costs being minimum is called the
ECONOMIC ORDER QUANTITY (EOQ).
EOQ is a very simple yet powerful tool to calculate various lot sizes in ideal
situations. It can be modified to accommodate numerous special conditions. The EOQ
concept is also based on the fact that ordering costs and inventory carrying costs are
calculated accurately. This is often not so. EOQ calculated is often an inconvenient
number, or orders could happen at odd points of time. EOQ fails when the goods in
question are seasonal goods. There are a number of statistical formulae adopted to
determine the safety stock level of individual items based on variations in the trend of
demand and consumption, degree of reliability placed on supplier’s delivery schedules
and the service level desired.
An inventory system provides the organizational structure and the operating policies
for maintaining and controlling goods to be stocked. The system is responsible for
ordering and receipt of goods: timing the order placement and keeping track of what
has been ordered, how much, and from whom. In a single-period model, the item
unsold at the end of the period is not carried over to the next period. The unsold items,
however, may have some salvage values.
Multi period inventory systems are designed to ensure that an item will be available
on an ongoing basis throughout the year. Usually the item will be ordered multiple times
throughout the year where the logic in the system dictates the actual quantity ordered
and the timing of the order. In a fixed-time period system, inventory is counted only at
particular times, such as every week or every month. Like forecasting, effectively
calculating your safety stock requirements can result in getting greater performance out
of fewer inventories. Unfortunately, most businesses do a lousy job of calculating safety
stock.

1. EOQ can be used in conjunction with various inventory management systems
including ____________.
(a) JIT
(b) ABC
(a) VED
(b) HML
2. There are a number of statistical formulae adopted to determine the ____________
stock level of individual items.
(a) Highest
(b) Lowest

(c) Safety
(d) Danger
Notes
3. Newspaper and magazines are also the examples of ______________ period
inventory model.
(a) Fixed
(b) Single
(c) Dynamic
(d) Static
4. The basic distinction is that fixed-order quantity models are "_________ triggered"
and fixed time period models are "time triggered.
(a) Event
(b) Cultural
(c) Value
(d) Loyalty
5. ______________ can also be used in banks and financial institutions to calculate the
daily currency requirements.
(a) JIT
(b) Overstocking
(c) Understocking
(d) EOQ
6. In constructing any inventory model, the first step is to develop a _____________
relationship between the variables of interest and the measure of effectiveness.
(a) Functional
(b) Multilevel
(c) Direct
(d) Indirect
7. The fixed-order quantity model favors more ____________ items because average
inventory is lower.
(a) Low cost
(b) Expensive
(c) High quality
(d) Low quality
8. If demand is constant, ___________ point is the same as the demand during the
lead time.
(a) Reorder
(b) Order
(c) Safety
(d) EOQ
9. _____________ stocks arise due to variations in consumption rates and variations
in lead times.
(a) Safety
(b) Over
(c) Under
(d) Balanced

10. Safety stock calculations use statistics to mitigate the ______ of stock out.
(a) Risk
Notes
(b) Problem
(c) Solution
(d) None of the above

(a) Fixed Order Quantity System
(b) Fixed Interval System
2. Inventory Management systems are concerned with answering a few simple
questions. What are they? What are the options available? Explain any two
inventory management systems and suggest where they can be used.
3. Discuss the P and Q systems of Inventory Management. Explain with diagrams.
4. What is safety stock? Determine the factors responsible for determination of safety
stock.
5. Explain the EOQ.
6. What are the strengths and limitations of EOQ concept.
7. Distinguish between P and Q models.
8. How when to order is determined?
5.9 Key Terms

z Economic Order Quantity: The quantity which when ordered and delivered results
in the total costs being minimum is called the Economic Order Quantity (EOQ). In
this situation, the Ordering Cost is equal to the Inventory Carrying Cost.
z Safety Stock: To meet the uncertainties arising from fluctuating demand,
fluctuating lead times, unforeseen situations etc. An extra stock is invariably
maintained for each item in the inventory. This extra stock is termed as buffer stock
or safety stock. Safety stock arises due to variations in consumption rates and
variations in lead times.
z Service Level: Service level can be defined as the inventory level where demand
for an item, group of items, or a system can be met from the in-hand stock. It is
expressed as a percentage of orders satisfied.
z Inventory System: An inventory system provides the organizational structure and
the operating policies for maintaining and controlling goods to be stocked.
z Fixed Order Quantity Model: Fixed-order quantity models attempt to determine
the specific point, R, at which an order will be placed and the size of that order, Q.

1. (a) JIT
2. (c) Safety
3. (b) Single
4. (a) Event
5 (b) EOQ
6. (a) Functional
7. (b) Expensive
8. (a) Reorder
9. (a) Safety

10. (a) Risks
Notes 5.10 Further Readings

New Delhi

Production Planning and Control 77
Unit 6: Production Planning and Control

Notes
Structure
6.1 Introduction
6.2 Concept and Classification of PPC
6.2.1 Objectives
6.3 Scope of PPC
6.4 Functions of PPC
6.5 Factors Determining PPC
6.6 Production Cycle
6.6.1 Production Cycle Activities
6.7 Measurement of Effectiveness of PPC
6.8 Importance of Production-Panning and Control
6.9 Organisation Structure of Production Planning and Control Department
6.10 Difference between Production Planning and Production Control
6.11 Main Elements of Production Planning and Control
6.12 Summary
6.15 Key Terms
Objectives
z Understand the scope and functions of production planning and control (PPC)
z Explain the classification of PPC
z Explain the factors determining PPC
z Discuss the production cycle
6.1 Introduction
Production Planning and Control may be defined as the direction and coordination of
the firm's materials and physical facilities towards the attainment of pre-specific
production goals in the most efficient available way. Production Planning and Control
(PPC) consists of the organisation and planning of the manufacturing processes,
routing, scheduling, dispatching, inspection, coordination and control of the materials,
methods, machines, tooling and operation time. The ultimate objective is the
organisation of supply and movement of materials and labour, machine utilization and
related activities in order to bring about the desired manufacturing results in terms of
quality, quantity, time and price.
Production planning defines what, where, when and why to produce a product and
who will produce that considering the relevant factors in mind. The functions of
production planning is to decide the production objectives, to determine the
manufacturing requirements, such as availability of materials, money, men, machines,

production processes, and other priority etc., within the scope of industrial unit, to make
production plans for efficient production of goods to cope with its sales requirements.
Notes
Planning may be defined as the determination of a course of action to achieve the
desired results. Planning involves the definition of objectives, and planning of
operations in terms of policies, plans and budgets which will establish the most
advantageous course for the company. Planning means determination of what is to be
done, how and where it is to be done, who is to do it and how results are to be
evaluated. Control may be defined as the monitoring of performance through a
feedback by comparing the results achieved with the planned targets so that
performance can be improved through proper corrective action. This mechanism is
responsible for subsequent adjusting, modifying and rendering plans and targets in
order to ensure the attainment of goals.
6.2 Concept and Classification of PPC

Production planning involves scheduling, estimating, and forecasting the future
demands for products. This takes into account customer orders, production capacities
and capabilities, forecasting of future trends, and inventory levels.
Once that is done, there are five main types of production planning: Job, Method,
Flow, Process and Mass Production methods. Each is based on different principles and
assumptions. Each has their own merits and demerits.
z Job Method: Under this method, the complete task of manufacturing a product is
handled either by a single worker or by a group. The type of jobs using this method
could be small scale or complex. This method is usually incorporated when
customer specifications are essential in the production. Tailors, cooks, and
hairdressers are all examples of professionals who use the Job method of
production planning. Small scale jobs are those for which production is relatively
easy, as the worker has the required skill-set for the job. Also relatively little
specialized equipment is usually needed in such tasks. Due to those
considerations, the customer's specific requirements can easily be included at
anytime during the progression of the job. Complex jobs involve the use of high
technology, making project control and management essential. Construction
businesses, for example, are complex operations that still use the Job method of
production planning.
z Batch Method: As businesses grow, and their production volumes grow with them,
the Batch method of production planning becomes more common. It requires the
division of work into parts. For a part of work to proceed it is essential that the
previous part gets completed. Electronic parts manufacturing businesses use the
batch method. The Batch method requires specialization of labor for each division.
z Flow Method: This method is similar to the batch method. Here the aim is to
improve material and work flow, reduce labor and labor costs and finish the work
faster. Unlike the batch method, where one batch is completed after another, in this
method, work progresses as a flow. Assembly lines that make televisions typically
use this method. The product is manufactured by a number of interconnected
operations in which the material moves one stage to the second without time lags
and interruptions.
z Process Method: Here the product is produced using a uniform and standardized
sequence. Highly sophisticated machinery is used here. The production is
continuous.
z Mass Production Method: In this method, goods are produced using standardized
techniques like balanced production and product-wise layout.]

6.2.1 Objectives
The principal objectives of the Production Planning and Control are as follows: Notes
(i) Quality of the Output: The most important objective of PPC is to ensure the safe
and economical manufacture of desired products in required quantity and in quality.
(ii) Plant Utilization: To ensure maximum plant utilization so that productivity of
highest degree' can be achieved.
(iii) Process Efficiency: To maintain maximum process efficiency by proper
coordination.
(iv) Delivery of Goods: To deliver the products to the customer when he wants it.
(v) Maintenance of Inventories: To maintain an adequate but not excessive supply of
finished goods and work in process flowing through the plant so that deliveries can
be made to the customers who may want the product in less than the manufacturing
time.
(vi) Flexibility: To maintain flexibility in manufacturing operations so that an occasional

rush job can be taken care of (e.g. fewer and valuable or old customers).
(vii) Optimisation of Resources: To achieve optimum utilization of resources through
maintaining a balanced level of inventory, production and employment level.
(viii) Effectiveness of Work: PPC ensures the right man on right job, at right place, at
right time, on right wages and salaries so that maximum effectiveness is obtained.
(ix) Labour Turnover: The objective of PPC is to minimise labour turnover.
(x) Absenteeism: To minimise and regulate the absenteeism PPC can be introduced.
(xi) Team Spirit: To develop the team spirit and feeling of brotherhoodness among
workers is another aim of PPC.
(xii) Ideas for New Methods: PPC aims at giving encouragement to the workers for new
ideas and new methods.
(xiii) Reduced Supervision: The other objective of PPC is to reduce supervision through
creating interest in work, right instructions in right time etc.
(xiv) Reduced Waiting Time: PPC aims at reducing waiting time arising due to want of
material, tools, equipment, supervision, inspection, deliveries etc.
(xv) Reduced Costs: To ensure minimum wastages and achieve minimum cost per unit.
6.3 Scope of PPC

Scope of PPC involves the following:
z Material: RM, components, spares; right quantity; right time
z Methods
z Machines & equipments
z Manpower
z Routing
z Dispatching
z Expediting
z Inspection
z Evaluating
z Cost control
z Estimating
z Loading & scheduling

6.4 Functions of PPC

Notes Production Planning and Control is a management tool employee for direction of the
manufacturing operations and their coordination with other objectives of the firm, in the
production system which is primarily defined by the dimensions of quality, quantity, time
and price. The function of production planning and control comprise:
z Materials: Raw materials, spares and components etc. must be available in the
correct quantities and specifications at the right time. To achieve this, we must do
right purchasing (right material, in right time, at right price, from right source, in right
quantity, in right place), standardisation, variety reduction, value analysis,
inspection etc.
z Methods: Choosing the best method from several alternatives. It involves the best
sequence of operations and the division of product into assemblies and
subassemblies, modified by the limitation of existing layout and work flow.
z Machines and Equipment: Methods have a relationship to the production facilities
available. It involves equipment replacement policy maintenance policy, procedures
and schedules, tool management etc.
z Manpower: To maintain availability of right manpower on right machines it right
times as well as to ensure proper utilization thereof.
z Routing: Routing prescribes the flow of work in the plant and is related to
considerations of layout, of temporary storage locations for raw materials and
components and of materials handling systems. Tooling is a fundamental
production function on which all subsequent planning is based.
z Estimating: Here the operation times are worked out by measurement leading to
fixing of performance standards, both for man and machine.
z Loading and Scheduling: Machines have to be loaded according to their capacity.
Machine loading is carried out in conjunction with routing to ensure smooth work
flow and with estimating to ensure that the prescribed methods, feeds and speeds
of machines are best utilised.
z Scheduling is the toughest part of the job in production because it determines the
utilization of equipment and manpower and hence the efficiency of the plant.
Scheduling must ensure that operations are properly dovetailed to ensure even flow
of work from one machine to the other and from one shop floor to the other. There
must be a balancing of operations.
z In machine loading, appropriate allowances are made for set up time for machines,
processes adjustment and maintenance down time and these allowance form part
of the data constantly used by the scheduling function.
z Dispatching: This is concerned with the execution of the planning functions. Orders
and instructions are released according to the plan, sequences are embodied in
route sheets and loading schedule authorisation is made for release of materials
and methods and trained manpower are put into action.
z Expediting: This means follow-up or progressing. It is a logical step after
dispatching. Dispatching initiates while expediting maintains the plan. This function
keeps a close liaison with scheduling in order to provide an efficient feedback and
prompt review of targets and schedules.
z Inspection: This function relates to maintenance of quality of production and of
evaluating the efficiency of the processes, method and manpower so that
improvements can be made.

6.5 Factors Determining PPC
Factors determining PPC are as follow: Notes
z Future rate of sales, production and inventory levels etc.
z Input requirements viz. raw materials, spare parts for machine and equipment,
capacity of plant and present load etc.
z Estimated output desired.
z Nature of operations, sequence of these operations and duration of each operation.
6.6 Production Cycle

The production cycle is a recurring set of business activities and related data
processing operations associated with the manufacture of products. Information flows to
the production cycle from other cycles, e.g.:
z The revenue cycle provides information on customer orders and sales forecasts for
use in planning production and inventory levels.
z The expenditure cycle provides information about raw materials acquisitions and
overhead costs.
z The human resources/payroll cycle provides information about labor costs and
availability. Information also flows from the expenditure cycle:
z The revenue cycle receives information from the production cycle about finished
goods available for sale.
z The expenditure cycle receives information about raw materials needs.
z The human resources/payroll cycle receives information about labor needs.
z The general ledger and reporting system receives information about cost of goods
manufactured. Decisions that must be made in the production cycle include:
What mix of products should be produced?
How should products be priced?
How should resources be allocated?
How should costs be managed and performance evaluated?
These decisions require cost data well beyond that required for external financial
statements. We’ll be looking at how the three basic AIS functions are carried out in the
production cycle, i.e.:
z How do we capture and process data?
z How do we store and organize the data for decisions?
z How do we provide controls to safeguard resources, including data?
6.6.1 Production Cycle Activities

The four basic activities in the production cycle are:
z Product design
z Planning and scheduling
z Production operations
z Cost accounting
Accountants are primarily involved in the fourth activity (cost accounting) but must
understand the other processes well enough to design an AIS that provides needed
information and supports these activities.

6.7 Measurement of Effectiveness of PPC

Notes The general effectiveness of the department can be measured by the company's
success in meeting its sales forecast and producing a quality product for the customer
when he wants it. More specifically there are 4 areas in which the effectiveness of PPC
can be measured.
z Delivery: This can be easily measured by a statement of deliveries overdue with
products for which they are overdue. A chart can also be made to show over a
period, say every half year or annually, the deliveries effected on time and those
delayed, with a delay-period analysis.
z Inventories: The inventory turnover, the value of inventories, obsolete items, non-
moving or surplus items etc. are all indicators of efficiency in inventory
management.
z Production Management: Comparison of planned and actual production will be an
indicator of performance. Overtime hours worked, machine utilization ratio etc. is
other indicators for measurement of effectiveness.
z PPC Department itself: The objective of the department should be to operate it
with the least total cost.
6.8 Importance of Production-Panning and Control

Production planning and control comes out with a number of factors which makes it
important not only for the company but also for the nation. The importance and
production planning and control are discussed below:
(i) India's Developing Economy Needs PPC: The importance of PPC can not be
over-emphasised, particularly under the present circumstances of India. We are
undergoing an era of planning. The main intentions behind industrial planning is to
accelerate the production so that our goods may find a suitable market abroad. But
the need for greater, better and cheaper, goods is out without proper planning and
adequate control. A successful production control programme minimises the
idleness of the men and machines and optimises the number of set ups required,
keeps in-process inventories at a satisfactorily level, reduced material handling and
storage costs and consequently permits quantity and quality at low unit costs.
(ii) Production Planning and Control is Factory's nervous system: The functions of
PPC in a factory can easily be compared with the nervous system in human
organism. It serves to co-ordinate the activities of a plant just like a nervous system.
Moore has also stressed that when simple repetitive operations are performed,
production control is accomplished more or less sub-consciously in the same
manner that the nervous system automatically regulates one's breathing when less
repetitive activity is involved, more conscious direction is necessary, both in the
plant and the human system; when a product contains thousands of parts, the
integration of the efforts of numerous personnel becomes a problem of major
proportions and one which justifies specialization of abilities.
(iii) Production Planning and Control is must for Intermittent Process industry: In
a continuous process industry where the raw materials enter at the end of factory
and flow through it in a steady stream, the problem of production control is clearly
very simple as the path or route that the material is to flow is fixed by the natural
sequence of processes and the times of operations are fixed largely by the capacity
of machines and processes. But in the intermittent process industry of the special
order type, where products are made only to customer's orders and where repetition
of such orders are unusual, the case is very different. Here each succeeding part
produced may follow a new way through the shop. The time required for each
operation may not be known and unlike the continuous process industry, the parts
do not move automatically from machine to machine but must be so moved as
occasion requires. Thus it is clear blat unless some supervision is given to the
sequence of part, congested conditions will arise in the factory. Some machines
having more work than they can do and some being under loaded and as a
consequence the product will not be produced at the time set for delivery. In the
majority of cases, some kind of production control is needed and this control is
usually attempted through a so-called production planning department. Notes
(iv) Production Planning and Control is an effective instrument of cost control: In
the absence of any well regulated plan of manufacturing activities, machines and
men facilities may not be used to their full capacity and idle or partially occupied
time of men and idle time of plant may go unnoticed. Again a poorly organised
system of production control must result in inefficiency as all the direct and auxiliary
factory costs will be difficult to control and wastes that are bound to occur will not be
reflected. In this way the concern will fail to maintain its competitive standing in the
consumer field. In short, production control serves as an effective instrument for
cost control.
(v) Production Planning and Control Rationalizes the Production Activities: The
chief object of production organisation is to stimulate production by ensuring an
orderly flow of materials and tools and full utilization of men and machine so as to
regulate productive activities in quality and technique from the raw state to the
finished product. It takes the influx of sales order, boils them down into production
orders and feeds them to the plant at a rate and in sequence that enables the plant
to digest them most readily and with minimum of internal disorder.
(vi) Other benefits of Production Control: The benefits of production control has
been classified as exerting influence on five segments of society. They are
summarized as below:
(A) The Consumers
(i) Increased productivity
(ii) Better values
(iii) Deliveries at proper time
(B) The Producers
(i) Adequate wages
(ii) Stable employment
(iii) Job security
(iv) Improved working condition
(v) Increased personal satisfaction
(C) The Investors
(i) Security of investments
(ii) Adequacy of return.
(D) The Community
(i) Economic and social stability.
(E) The Nation
(i) Security
(ii) Prosperity.
6.9 Organisation Structure of Production Planning and Control

Department
The nature of production planning and control department can be divided in three broad
categories viz. centralised decentralised and through progress men.

A centralised production planning and control department is headed by the

manager who is responsible to the works manager.
Notes
Works Manager
Production Planning and Control Manager
Production Materials Inventory Receiving

Engineering Manager Control and
Section Section Shipping
Section
z to determine manufacturing methods

z prepares operation sheets and instruction cards
z determines time standards
Such system provides better co-ordination of production and service activities with a
better basis for taking corrective action. But a centralised production planning and
control department cannot have direct knowledge about the actual conditions in the
production system and may not be able to adapt quickly to changing local conditions.
There is also a possibility of clash with areas of line authority.
Under decentralised production planning and control system each foreman has his
own group functioning under his authority. In such set up the foreman is well used to
local conditions of the environment and can have complete control over work
assignments and various operations. But there may not be any co-ordination over the
planning and control activities among different departments which may adversely effect
the fulfillment of overall objective.
Control through progressmen consists in placing a number of work orders under the
responsibility of a progress man who chases each order through the various
departments till it is ready for delivery. In such system the progress man can assign
priority to an order to expedite urgent orders. But there is limited scope for overall
planning and co-ordination and when work load approaches plant capacity, system
suffers from extreme stresses.
6.10 Difference between Production Planning and Production

Control
Functions of planning and control in production management are closely related with
each other. Planning concerns with the formulation of production strategies and targets
for the enterprise whereas control is vested with actual implementation and execution of
planned objectives. Production planning determines the operations required to
manufacture some product and controls, regulates and supervises these operations.
Through production control information the organisation can locate the shortcomings in
the planning process and the necessary modifications can be done at the time of
planning in future. Similarly production control operations can be improved to adjust
with the planning requirements.
MODIFICATIONS
PLANING OPERATIONS CONTROL
INFORMATION

The cycle of planning, operation, control, flow of information and modification is
illustrated by the above figure.
Notes
6.11 Main Elements of Production Planning and Control
During the course of planning and controlling the production process, the following
elements or techniques or steps should be followed in a phased manner. We may also
call them ‘production planning and control functions’. These are (i) routing, (ii) loading,
(iii) scheduling, (iv) dispatching and (v) follow-up or expediting.
(i) Routing: Routing means determining the route path for the movement of a
manufacturing lot through the factory. Which work will follow and the sequence of
various operations is determined in advance so that a minimum of handling,
transportation, storage and deterioration through exposure may be managed. The
aim of routing is to determine the most feasible sequence of operations and it
permits the best utilisation of physical human resources in production. It is first and
the foremost function of production planning and control because other functions
depend upon routing.
(ii) Loading: After establishing the route the next function is loading of work against
the concerned machine and equipment. Loading deals with the amount of work
assigned to a machine or a worker. The person concerned with these loading
functions must be up-to-date in keeping all the records of the workload and capacity
of each machine and shop. The total time required to complete the workload is
computed multiplying the unit operation time given on the standard process sheet
by the number of parts planned for the work station. It results in tabulated list or
chart showing the planned utilisation of machines in the plant. The chart helps in
assessing the spare capacity. If chart shows spare capacity, efforts should be
directed towards obtaining more orders just to utilise the spare capacity. But if a
machine is overloaded, the action on any one or more of the following lines may be
taken:
(a) arrangement of overtime work;
(b) sub-contracting of the excessive work-load;
(c) transfer of some of the operations to another shop or machine which is being
under utilised; and
(d) introduction of an additional shift.
(iii) Scheduling: Scheduling determines when the various operations are to be
performed and consists of the assignment of starting and completion time for
various operations to the performed. Scheduling and routing should be integrated.
Both are interdependent to do the work efficiently. The other information required to
draw production schedules include (a) date of delivery as mentioned by the
customer in his order; (b) past production records; (c) production capacity of the
plant; and (d) availability of equipment, materials and specialised skills.
(iv) Dispatching: Dispatching deals with setting the productive activities in motion
through release of orders and instruction in accordance- with the predetermined
timings as given in operation set route card and loading schedules. It is official
authorisation and information for (a) movement of materials to different workplaces;
(b) movement of tools and equipment to different machines, necessary for each
operation; (c) beginning of work; (d) recording of beginning and completion time; (e)
movement of work in accordance with the routing schedule; (f) recording the
progress of all operations; and (g) making of necessary adjustments in the release
of instructions, if necessary.
(v) Expediting or Follow-up: Expediting or follow-up helps to ensure that necessary
instruction have been followed by the concerned man in the desired direction. It
ensures that the materials and tools and equipment are received by the workers in
right time for various operations. It helps to reveal the defects in routing and
scheduling and in the line of communication. It also reveals whether the workshop

is over or under loaded. The responsibility for follow-up is given to a group known
as ‘follow-up men’. The function may be performed product wise.
Notes The above functions of production planning and control may be performed
effectively if corrective measures are taken in time. By resorting to such measures,
production manager maintains full control over the production activities. Production
manager should be fully authorised to mend the routing and production schedules
in order to maintain complete harmony among the various activities and to ensure
best utilisation of the plant capacity. Corrective measures are also warranted if
production schedules are disturbed by abnormal situations like power breakdown or
strike. The production manager should also evaluate the performance of the worker
to ensure the quality production in scheduled time.
6.12 Summary
Production planning involves scheduling, estimating, and forecasting the future
demands for products. This takes into account customer orders, production capacities
and capabilities, forecasting of future trends, and inventory levels. Once that is done,
there are five main types of production planning: Job, Method, Flow, Process and Mass
Production methods. Each is based on different principles and assumptions. Each has
their own merits and demerits. Production Planning and Control is a management tool
employee for direction of the manufacturing operations and their coordination with other
objectives of the firm, in the production system which is primarily defined by the
dimensions of quality, quantity, time and price.
The production cycle is a recurring set of business activities and related data
processing operations associated with the manufacture of products. Information flows to
the production cycle from other cycles. The four basic activities in the production cycle
are Product design, Planning and scheduling, Production operations and Cost
accounting.
The importance of PPC can not be over-emphasised, particularly under the present
circumstances of India. We are undergoing an era of planning. The main intentions
behind industrial planning are to accelerate the production so that our goods may find a
suitable market abroad.
Control through progressmen consists in placing a number of work orders under the
responsibility of a progress man who chases each order through the various
departments till it is ready for delivery. In such system the progress man can assign
priority to an order to expedite urgent orders.
Functions of planning and control in production management are closely related
with each other. Planning concerns with the formulation of production strategies and
targets for the enterprise whereas control is vested with actual implementation and
execution of planned objectives. Production planning determines the operations
required to manufacture some product and controls, regulates and supervises these
operations.

1. __________ ___________defines what, where, when and why to produce a
product and who will produce that considering the relevant factors in mind.
(a) Routing
(b) Scheduling
(c) Expediting
(d) Production Planning

2. __________ may be defined as the monitoring of performance through a feedback
by comparing the results achieved with the planned targets so that performance can
be improved through proper corrective action. Notes
(a) Planning
(b) Control
(c) Activity
(d) Verification
3. Production planning involves scheduling, estimating, and ________ the future
demands for products.
(a) Forecasting
(b) Planning
(c) Controlling
(d) Routing
4. ___________ prescribes the flow of work in the plant and is related to considerations
of layout, of temporary storage locations for raw materials and components and of
materials handling systems.
(a) Expediting
(b) Batch
(c) Job
(d) Routing
5. _______ is concerned with the execution of the planning functions.
(a) Dispatching
(b) Planning
(c) Flowing
(d) Scheduling
6. The production cycle is a __________ set of business activities and related data
processing operations associated with the manufacture of products.
(a) Recurring
(d) Temporary
(c) Permanent
(d) None of these
7. _________ deals with the amount of work assigned to a machine or a worker.

(a) Unloading
(b) Loading
(c) Production Planning
(d) Production Cycle

8.____________ or follow-up helps to ensure that necessary instruction have

been followed by the concerned man in the desired direction.
Notes
(a) Expediting
(b) Locking
(c) Loading
(d) Routing
9. ___________ concerns with the formulation of production strategies and targets for
the enterprise whereas control is vested with actual implementation and execution of
planned objectives.
(a) Planning
(b) Controlling
10. A _________ production planning and control department is headed by the

manager who is responsible to the works manager.
(a) Decentralised
(b) Centralised
(c) Formal
(d) Informal

1. Define planning and control.
2. What is production planning and control?
3. Discuss the classification of Production planning and control.
4. What are the objectives of PPC?
5. Discuss the scope and functions of PPC.
6. What are the factors determining PPC?
7. Describe the concept of production cycle.
8. What are the four major production cycle activities?
6.15 Key Terms

z Modular Production: The principle employed in modular production is to design,
develop and produce the minimum number of parts or operations called (modules)
that can be combined in the maximum number of ways to offer the greatest number
of products or services.
z Planning: Planning may be defined as the determination of a course of action to
achieve the desired results.

z Control: Control may be defined as the monitoring of performance through a
feedback by comparing the results achieved with the planned targets so that
performance can be improved through proper corrective action. Notes
z Production Planning and Control: It may be defined as the direction and
coordination of the firm's materials and physical facilities towards the attainment of
pre-specific production goals in the most efficient available way.
z Production Planning: Production planning defines what, where, when and why
to produce a product and who will produce that considering the relevant factors in
mind.

1. (d) Production planning
2. (b) Control
3. (a) forecasting
4. (d) Routing
5. (a) Dispatching
6. (a) recurring
7. (b) Loading
8. (a) Expediting
9. (a) Planning
10. (b) Centralised

Adam & Ebert, Production and Operations Management – Concepts, Models and
Behavior, Prentice Hall of India, 1992
Bradley Gale, Managing Customer Value: Creating Quality and Service that Customers
can see, Free Press, NY, 1994
Buffa and Sarin, Modern Production/Operations Management, John Wiley & Sons,
1994
Chase, Jacobs, Aquilano, Operations Management for Competitive Advantage, Tata
McGraw Hill, Delhi, 2004
Krajewski and Ritzman, Operations Management, Strategy and Analysis, Pearson
Education; 2002

Unit 7: Forecasting
Notes
Structure
7.1 Introduction
7.2 Why Forecast?
7.4 Dependent Demands
7.5 Independent Demands
7.6 Semi-Dependent Demands
7.7 Lead Time Management
7.8 Considerations in Forecasting
7.9 Demand Forecasting Techniques
7.9.1 Qualitative Techniques
7.9.2 Quantitative Techniques
7.10 Causal Relationships using Cause and Effect Models
7.10.1 Simulation
7.11 Summary
7.14 Key Terms
Objectives
z Define the steps and Types in forecasting
z Understand demand forecasting
z Explain forecasting techniques
z Distinguish between the qualitative and Quantitative techniques
7.1 Introduction
Planning is the first and foremost function of management and is the foundation or basis
for the succeeding functions of organizing, staffing, directing and controlling. Business
activities in general and industrial/manufacturing/marketing activities in particular,
involve decisions and actions which have very long term implications or gestation
periods. This makes it necessary for senior managers to virtually live in the future or at
least be very futuristic in their outlook. In fact, the planning horizon of managers is
directly proportional to their seniority, Top Management being concerned with the
Strategic (Long term) Planning, Middle Management with Tactical (Medium term)
planning and lower level management with operational (Short term) planning. The
common characteristic of all future periods, whether they be the next few days /
months/years is uncertainty or at least lack of knowledge with certainty of the likely
future events and environment. That makes it necessary to make guesses/estimates
about the future and that has been understood as Forecasting. The dictionary meaning
of forecast is, estimate, conjecture, beforehand, foresight, prudence, conjecture
estimate of something in the future, etc.

Forecasting 91
7.2 WHY FORECAST?
Predicting the future is all the more important in materials management. While the Notes
present moment is the right time for the user or customer, the right time for the provider
or the materials manager for taking action to be in possession of the material in the
present was well into the past, to be precise, at least equal to the Lead Time for its
ordering and delivery. At his right time, back in the past he was not only required to take
action but also decide how much to provide for, which is his forecasting of the future
likely demand. Every area of logistics is affected in some way by the forecasting
process: that is, conducting or developing forecasts, providing information to be used in
forecasting, or receiving forecasting results and implementing necessary actions. While
other activities of logistics are more actively involved in the forecasting process,
inventory management utilizes forecasts employed in MRP and DRP efforts, and is
indirectly affected by the forecasts developed by others. Forecasting attempts to predict
the future through qualitative or quantitative methods, or some combination of both. The
essence of forecasting is to aid inventory control decision making.
A study of the forecasting practices of a large number of companies indicated that
the most widely cited reasons for forecasting included:
(a) Increasing customer satisfaction
(b) Reducing stock outs
(c) Scheduling production more efficiently
(d) Lowering safety stock requirements
(e) Reducing product obsolescence costs
(f) Managing shipping better
(g) Improving pricing and promotion management
(h) Negotiating superior terms with suppliers
(i) Making more informed pricing decisions
7.3 Types of Forecasts

z Effective and efficient materials management and inventory control requires many
types of forecasts, including,
(a) Demand Forecast: Investigation of the firm’s demand for the item to include
current and projected demand, inventory status and lead times. Also considered
are competing current and projected demands by industry and product end use.
(b) Supply Forecast: Collection of data about current producers and suppliers, the
aggregate projected supply situation, and technological and political trends that
might affect supply.
(c) Price Forecast: Based on information gathered and analyzed about demand
and supply, provides a prediction of short and long-term prices and the
underlying reasons for those trends.
z Additionally, forecasts can be short term, midrange or long term; typically, firms
would use all three types of forecasting.
Long-term Forecasts: Usually cover more than three years and are used for
long range planning and strategic issues. These will be performed in broad
terms, that is, sales by product line or division, throughput capacity by ton per
period or dollars per period.
Midrange Forecasts: Usually range from one to three years and address
budgeting issues and sales plans. Again, these might predict more than
demand.

Short-term Forecasts: Are most important for the operational logistics

planning process. They project demand into the next several months and, in
Notes some cases, more than a year ahead. These are needed in units, by actual
items to be shipped, and for finite periods of time – monthly or perhaps weekly.
z Another classification of forecasting could be based on the future situation.
Forecasting in Situations of Certainty: We may know exactly what the future
demand will be. This is not a very frequent case, but it may be illustrated by the
construction of a skyscraper with regard to the inventory of girders. In such a
case we might well know exactly how many girders we would need during each
week of construction. Another instance will be of materials planning based on
end products. Requirement of various materials is arrived at from the bill of
materials, using explosion charts.
Forecasting in Situations of Risk: We may know the probability of distribution
of future demand. Such information is likely to be available if the item in
question is one for which records of past demand are available. An example
might be the inventory of tyres for a taxicab fleet or the inventory of bread in a
supermarket. It is assumed that the past patterns, by and large, repeat itself.
However, this assumption is tempered with judgement based on anticipated
changes or fully/partly known factors. One thus operates in a situation of risk.
Statistical operational research techniques come in handy in this situation.
Forecasting in Situations of Uncertainty: We may be entirely ignorant of the
likelihood of various levels of future demand. An example might be the
inventory problem of plant capacity for a new product for which there are no
existing market analogies. Another example could be materials planning for
maintenance of newly introduced equipment or machinery. Little is known about
the usage characteristics and consumption pattern of the equipment. The
recommendation of the manufacturers may be inadequate, biased and not
relevant to our own environment. In such cases, forecasting is based on
intelligent assessment of grey, if not dark areas by pooling of informed opinions
or setting up committees of experts. Technological forecasting techniques like
Delphi Technique or Gross Impact Matrix are useful in such situations.
7.4 DEPENDENT DEMANDS

An item is said to exhibit ‘Dependent Demand’ characteristics when its use is directly
dependent on the scheduled production of the larger component or parent product of
which the item is a part. Once the total quantity of end product to be manufactured
during a period is known, the precise requirement of inputs can be worked out from the
Bill of Materials (BOM). Dependent Demand should not be forecasted but precisely
calculated, even though the demand for the end product might have been forecast. For
every motorcycle to be produced, two wheels are needed. The number of motorcycles
produced, can be forecast, but the number of wheels required have necessarily to be
calculated, depending on the number of motorcycles made. This is dependent demand.
7.5 INDEPENDENT DEMANDS

Those items for which the demand cannot be calculated accurately from the
production schedule and bills of materials are said to have an ‘Independent
Demand’. Such demand can only be forecast and not calculated precisely. The
demand for a consumer durable in the market is not dependent on any predictable
factor since the tastes and needs of consumers vary. The consumers can choose what,
where and when they will buy. Similarly, spares required for day-to-day operation and
maintenance of machinery may be entirely probabilistic and independent of any specific
factor.
In an iron making facility, iron ore, coal, limestone and manganese ore have a
dependent demand whereas furnace oil, refractory bricks, gallery lights and conveyor
belts have an independent demand.

Forecasting 93
The distinction is relatively simple but very essential to the inventory manager. It
helps him to decide what should be the inventory control policy applicable for the item.
Notes
7.6 SEMI-DEPENDENT DEMANDS
A third category of semi-dependent demands could be thought of in the context of
overhaul of vehicles or aircraft or rotables. After strip and survey of the main
equipment, many components may have to be replaced based on their condition of
wear and tear, the criterion being whether they could safely operate for another
overhaul life or TBO (Time Between Overhauls) or not. This is usually done based on
the experience of overhaul of a large number of overhauls which is reduced to a “ten-
off-list” or a list of spares replaced on an average for overhaul of ten pieces of
equipment. As the age of the equipment increases the wearing pattern changes and it
gets reflected in the updated “ten-off-lists”.
7.7 LEAD TIME MANAGEMENT

Safety stock is a function of two parameters:
z Consumption rate
z Lead Time
The various combinations of the two factors are possible. These are:
1. Both Consumption Rates and Lead Times are constant.
2. Consumption Rate varies but Lead Time is constant
3. Consumption Rate is constant but Lead Time varies
4. Both Consumption Rate and Lead Time vary
We now proceed to examine each of these in detail.
1. Both Consumption Rates and Lead Times are Constant: This is an ideal
situation. No safety stock is required. Supply against the fresh order will arrive just
when the quantity against the previous order has been exhausted.
Order Order arrival
Inventory placed next order placed
200
Average
inventory
100
0 10 20 30 40 days
Figure 7.1: Situation when Both Consumption Rates and Lead Times are Constant
2. Consumption Rate varies but Lead Time is Constant: In the previous example,
consumption rate (CR) is 200/10 = 20 units/day.
Let the CR increase to 25 units/day, while lead time remains at 10 days.
The inventory would become zero on day–8 (200/25). So there would be a
stock out for 2 days, i.e. stock out of 50 units in total.
We can thus say that if the variation in demand is + or – 5 units, a safety stock
of 50 units would be required to be maintained, to take care of variations
in demand.
The average inventory would therefore be 200/2 + 50 = 150 units.

This can be represented diagrammatically as follows:
Notes
.2: Situation when Consumption Rate Varies but Lead Time is Constant
3. Consumption Rate is Constant but Lead Time Varies: We will still continue with
the previous example.
Let the CR remain at 20 units/day, while lead time varies by 2 days. If it arrives
2 days earlier, there is no problem. But if it arrives 2 days late, there would be a
stock out for 2 days. So the stock out quantity will be 20 × 2 = 40 units.
We can therefore say that if the variation in lead time is + or – 2 days and never
more, a safety stock of 40 units would be required to be maintained, in order to take
care of variations in lead time.
Figure 4.3: Situation when Consumption Rate is Constant but Lead Time Varies
4. Both Lead Time and Consumption Rate Vary: As in the previous examples, let
the consumption rate (CR) increase to 25 units/day, and lead time increase
to 12 days.
The inventory would become zero on Day 6, i.e. there would be a stock out for 4
days at 25 units per day i.e. stock out of 100 units in total.
Therefore, a safety stock of 100 units would be required to be maintained, to take
care of variations in demand.

Forecasting 95
Notes
Figure 4.4: Situation when Both Lead Time and Consumption Rate Varies
All these cases discussed so far are called the Rough Method or Rule of Thumb
Method. They do not have any scientific basis. Also they cannot provide any assurance
against stock outs and the firms could end up holding inventory either more or lesser
than necessary. A more effective method is the use of statistical methods based on
the concept of service level.
7.8 CONSIDERATIONS IN FORECASTING

The following are some of the considerations which should act as a guide in forecasting:
(a) Forecasting is more accurate for a larger group
(b) Forecasts for shorter periods are more accurate
(c) Forecasts should include an estimate of error
(d) Forecasting systems should be tested
(e) Forecasting needs a sound data base
7.9 DEMAND FORECASTING TECHNIQUES

Numerous techniques are available for forecasting, and they can be broadly classified
into two categories (a) Qualitative Techniques and (b) Quantitative Techniques.
7.9.1 Qualitative Techniques

They involve collection of opinions and preferences, which are further quantified using
different statistical tools. The most commonly used qualitative techniques are:
(a) Grass roots
(b) Consensus forecasting
(c) Delphi method
(d) Historical analogy
(e) Market research
These are explained below:
(a) The Grass Roots method is the simplest method of forecasting. It starts with
estimates and opinions and the final forecast is arrived at from these estimates by
review and discussion. Its advantage lies in its simplicity and the association of all
the people who matter. For example, the overall sales forecast may be derived by
combining the inputs from each sales person, who is responsible for sales in his or
her territory. It does have the advantage of simplicity, but suffers from the
disadvantage of being highly subjective. It may also be time consuming and is very
much influenced by immediate events.

(b) The Consensus method believes that open discussion by a group would produce
better forecasts than any single individual’s endeavour.
Notes (c) The Delphi method was developed by the Rand Corporation in the 1950s. In this
method, a panel of experts is selected and their comments are crystallized from
their responses to a series of questionnaires. It is of special relevance in situations
of uncertainty. There is a learning process for the group members too and at the
same time, there is no influence of group pressure or dominating individuals as the
identity of the individual is often concealed.
(d) The Historical Analogy method ties up the forecast to a previous forecast. This
method is specially relevant when new products are being launched, where a
forecast may be derived by using the history of a similar product. You just need to
click on any site selling books and you will be flooded with mails offering all kinds of
books! The products are in the same general category of books and may be bought
by the consumers. Similarly, a firm which already produces kettles and now wants
to produce electric kettles could use the kettle history as a likely growth model.
(e) The Market Research method is based on surveys conducted and is usually
employed by organizations to forecast new product sales or sales of established
products in new markets. Data is collected in a variety of ways such as surveys,
interviews, questionnaires etc. to test hypothesis about the market. You would
certainly not have escaped telephone calls, asking you about newspaper
preferences, your income, habits and so on.
7.9.2 Quantitative Techniques

These techniques are of three types:
z Time Series Analysis
z Causal relationships using cause – effect Models
z Simulation
Time Series Analysis

It uses historical data to predict the future. In this method, the element of time comes
into the picture. Time can be short-term, medium-term or long-term. While these terms
are relative to the context in which they are used, a short-term often refers to a time
period of under three months, medium-terms refers to three months to two years and
long-term is more than two years.
Several forecasting methods are available; which method to choose would depend
on the following factors:
z Time period of forecast
z Data availability
z Accuracy desired
z Size of budget available
z Availability of qualified personnel.
The most commonly used methods of time series analysis are:
(i) Last Period Demand Method
(ii) Simple Average Method
(iii) Weighted Moving Average Method
(iv) Exponential Smoothing
(v) Trend Projections
(vi) Regression Analysis
(vii) Shiskin Time Series

Forecasting 97
(viii) Box Jenkins Technique
(i) Last Period Demand Method is the simplest method based on past demand. It does
not take into account seasonal fluctuations and so may not always be foolproof.
Notes
(ii) The Simple Average method smoothens random fluctuations. When the demand for
a product is neither growing nor declining rapidly, and does not show seasonal
characteristics, this method of forecasting can be useful. But this method also does
not take into account seasonal fluctuations. The formula for calculation is:
where,
Ft = Forecast for the coming period
A(t – 1), A(t – 2) .......... + A(t – n) = Actual occurrence in the past period
N = No. of periods to be averaged
(iii) Weighted Moving Average Method is useful in guarding against random fluctuations
due to seasonal demand characteristics. Weights are assigned to each component
of the moving average database, provided that the sum of all weights is exactly
equal to 1.
We can understand the above three methods by means of an example.
Example
Sturdex Mopeds Limited has the following demand data for their mopeds for the past 6
months:
Month Demand of
Mopeds
April 1500
May 2000
June 2300
July 1700
August 1000
September 1200
We need to forecast the demand for October. We will do it by the various methods
we have learnt above.
(a) Last Period Method: Since demand for September was 1200 units, the forecast for
October would be 1200 units.
1500 + 2000 + 2300 + 1700 + 1000 + 1200
(b) Simple Average Method: = 1616 units
6
(c) Moving Average Method: In considering a 4-period Moving Average method to
forecast sales for October, we will consider the sales for the last four months and
get the forecast as follows:
2300 + 1700 + 1000 + 1200
= 1550 units
4
(d) Weighted Average Moving Method: Let us assume that the analyst assigns
weights of 3, 2, 1, 2, 4 and 3 for the sales from April to September. The revised
forecasted demand would then be:
3(1500) + 2(2000) + 1(2300) + 2(1700) + 4(1000) + 3(1200)
= 1453units
15

In the exponential smoothing method, random errors are smoothened by giving

exponentially decreasing weights to historical data. This weight is called a and
Notes varies between 0 and 1.
In the previous example, suppose the actual demand for October was 1200
units against the forecast of 1453 units. Considering a as 0.5 (which the company
feels, produces best results), the demand for November would be:
1453 + 0.5(1200-1453)
1453 – 126 = 1327 units
(iv) Exponential Smoothing: The drawback of the methods discussed so far is that as
each new piece of data is added to these methods, the oldest observation is
dropped and the new forecast is calculated. Also, in most cases, the more recent
occurrences are a better indicator of the future than the past occurrences. But in the
exponential smoothing method, only three pieces of data are needed to forecast the
future – the most recent forecast, the actual demand that occurred during that
period and the smoothing constant alpha (a). Alpha is given a value between 0
and 1. If the real demand is stable, say the demand for food, we would like a small
alpha to lessen the effect of short-term or random changes.
(v) Trend Projections: This method fits a trend line to the data points to get trend
projections and projects it into the future.
(vi) Regression Analysis: Regression is defined as a functional relationship between
two or more correlated variables. The relationship is developed from observed data.
The data is plotted first to see if they appear linear or at least parts of the data are
linear. This method is useful for long-term forecasting of major occurrences and
aggregate planning.
(vii) Shiskin Time Series: This method was developed by Julius Shiskin of the Census
Bureau. This method is used to decompose a time series into trends, seasonal and
irregular. It needs at least three years of historical data. It is very good in identifying
turning points, for example, in company sales.
(viii) Box Jenkins Technique: This method is very complicated but one of the most
accurate statistical techniques available. It relates a class of statistical models to
data and fits the model to the time series by using Bayesian posterior distribution.
7.10 Causal Relationships using Cause and Effect Models

This method focuses on the system underlying and influencing the item under forecast.
For example, sales may be affected by advertising, presence of competitors or quality.
Forecasting using cause-effect models is done by using the following methods -
(a) Correlation Regression method
(b) Econometric method
(c) Input-output analysis
(d) End use Analysis
(a) The Correlation Regression Method is similar to the time series method. Only it
contains multiple variables. The basis is that the forecast is caused by the
occurrence of other events.
(b) Econometric studies are considered very useful in case of long-term forecasts
and are considered very accurate. They are based on econometric models
describing some area of economic activity. All the parameters of the regression
equations are usually estimated simultaneously. These models are very expensive
to develop but are very accurate. They are often used for aggregate demand
analysis. Econometric models are based on mathematical statistics, a theory which
tells us how to make inferences about a population (gross number) on the basis of a
sample. Usually, firms in an industry are not too numerous and it is not useful to
select a representative sample from a cross section study of firms in an industry.

Forecasting 99
Another difficulty is that firms cannot neglect the random variables in the
relationship to be considered, which is not exact but probabilistic.
(c) Input-Output model focus on sales of each industry to other firms/government. It
Notes
indicates the change in sales that a product industry might expect because of
changing in purchasing patterns by other industries.
(d) End Use Analysis or leading indicators takes into account statistics that move in
the same direction as the series being forecast. For example, an increase in the
price of petrol would indicate a future drop in the sales of cars.
7.10.1 Simulation
These are dynamic models, usually computer-based, that allow the forecaster to make
assumptions about the internal variables and external environment in the model.
Depending on the variables in the model, the forecaster asks questions such as what
would happen to my forecast if price would increase by 10%. What effect would a 3%
drop in GDP have on my forecast?
Such studies are however, considered to fall in the realm of specialists and not
Materials Managers. These methods combine economic theories with statistical
procedures.
7.11 Summary
Business activities in general and industrial/manufacturing/marketing activities in
particular, involve decisions and actions which have very long term implications or
gestation periods. This makes it necessary for senior managers to virtually live in the
future or at least be very futuristic in their outlook.
Forecasting is one of the essential tools required by a materials manager to help
him anticipate changes and be prepared for the same. It helps him to correlate the
forces of demand and supply. There are two distinct drivers of demand and supply –
Quantity and Price.
Higher the price for an item, the lower would be the demand for the item, yet the
greater would be the incentive for suppliers to supply the item. Conversely, lower the
price for an item, greater would be the demand for that item, yet there would be less
supply of the item, due to its low price. Generally, therefore, the market will determine
the equilibrium price P1 and the quantity Q1 for an item.
Due to these dynamics, the suppliers in the consumer market place tend to focus
more on supply than demand, carrying out market research to determine what the
wants are in the market place and delivering products to satisfy those wants. Suppliers
also use marketing strategies to try to increase the quantum of want for their products.
In the Business to Consumer (B2C) market, therefore, Supply leads Demand.

1. Predicting the __________ is all the more important in materials management.
(a) Usage
(b) Production rate
(c ) Future
(d) Demand
2. An item is said to exhibit ‘_____________ Demand’ characteristics when its use is
directly dependent on the scheduled production of the larger component or parent
product of which the item is a part.
(a) Dependent

(b) Independent
Notes
(d) None of these
3. A more effective method is the use of statistical methods based on the concept
of ____________ level.
(a) Service
(b) Supply
(c) Inventory
(d) Demand
4. ____________ method was developed by Julius Shiskin of the Census Bureau.
(a) Trend Projection
(b) Regression Analysis
(c) Simulation
(d) Shiskin Time Series
5. The ______________ method believes that open discussion by a group would
produce better forecasts than any single individual’s endeavour.
(a) Consensus
(b) Exponential
(c) Regression Analysis
(d) Trend Projection
6. The Historical Analogy method ties up the forecast to a __________ forecast.
(a) Previous
(b) Present
(c) Future
7. Data is collected in a variety of ways such as surveys, interviews, questionnaires
etc. to test _______________ about the market.
(a) Scene
(b) Trend
(c) Data Availability
(d) Hypothesis
8. ______________ Demand Method is the simplest method based on past demand.
(a) Last Period
(b) Economy
(c) Scenario
9. In the exponential smoothing method, only _________ pieces of data are needed to
forecast the future.
(a) Three
(b) Two
(c) One
(d) Four
10. ______________ is very complicated but one of the most accurate statistical
techniques available.

Forecasting 101
(a) Box Jenkins Technique
(b) Shiskin Time Series
Notes
(c) Time Series Analysis
(d) Input-Output Model

1. What is forecasting? Why is it done and what are its uses? List some considerations
that should be taken into account while forecasting.
2. List the various classifications of forecasting.
3. List the various forecasting techniques available.
(a) Dependent
(b) Independent demand
5. What are statistical techniques of forecasting?
6. Write a note on Time-Series Analysis.
7. Explain the various qualititative forecasting techniques.
8. What are the methods of forecasting using cause-effect model?
7.14 Key Terms

z Dependent Demands: An item is said to exhibit dependent demand characteristics
when its use is directly dependent on the scheduled production of the larger
component or parent product of which the item is a part.
z Independent Demands: Those items for which the demand cannot be calculated
accurately from the production schedule and bills of materials are said to have an
Independent demand.
z Lead Time Management: It is managed through placement of safety stock which is
a function of two parameters: Consumption rate and lead time.
z Grass Roots: It is the simplest method of forecasting. It starts with estimates and
opinions and the final forecast is arrived at from these estimates by review and
discussion. Its advantage lies in its simplicity and the association of all the people
who matter.
z Consensus Forecasting: The consensus method believes that open discussion by
a group would produce better forecasts than any single individual's endeavor.
z Delphi Method: The Delphi method was developed by the Rand Corporation in the
1950s. In this method, a panel of experts is selected and their comments are
crystallized from their responses to a series of questionnaires. It is of special
relevance in situations of uncertainty.
z Historical Analogy: The Historical Analogy ties up the forecast to a previous
forecast. This method is especially relevant when new products are being launched,
where a forecast may be derived by using the history of a similar product.
z Market Research: Market research is based on surveys conducted and is usually
employed by organizations to forecast new product sales or sales of established
products in new markets. Data is collected in a variety of ways such as surveys,
interviews, questionnaires.

1. (c) Future
2. (a) Dependent
3. (a) Service

4. (d) Shiskin Time Series

5. (a) Consensus
Notes
6. (a) Previous
7. (d) Hypothesis
8. (a) Last Period
9. (a) Three
10. (a) Box Jenkins Technique

New Delhi
Case Study
WHEN FORECASTING FOR PRICE ASSESSMENT IS NOT BEING USED

The Lowells’ Company is a manufacturer of electrical appliances for the consumer
market. Its major product line consists of several models of electrical switches for both
homes and offices. The switches division generates over 90% of the firm’s annual
sales, which was approximately ` 30 crore last year. Over the years, the company had
earned the reputation of being a low cost good quality producer.
Several years ago, the company introduced a new model of the switch that was
extremely successful. The model was an advanced electronic switch which minimised
the chances of a shock. During the design stage of the product, the marketing
department had conducted an extensive survey to determine exactly what style and
colour combinations were desired by the consumer. The style finally selected was a
sleek futuristic contour in white and beige, with features of safety and cut-off.
From a cost and pricing point of view, the new product fitted the company’s basic
operating strategy very well. The firm typically priced its products 15-20% lower than its
major competitors. This pricing policy was made possible mostly because Lowell was
essentially a ‘design and manufacture’ type of operation that purchased its basic raw
materials and components in large volumes from large manufacturers and supply
houses. The capacity of production was huge, and largely automated; the production
planning and production were generally in line with the sales forecasts and the
expertise of the employees was good.
During the past 6 months, Lowell’s costs have been increasing at a level
significantly higher than the producer price index for their own finished goods. In-
process inventories have also increased significantly, coupled with loss of production
and increase in indirect labour costs. Breakdowns seemed to be occurring more
frequently. Consequently, the firm’s profit margin and its return on investment had
begun to drop noticeably.
A section of the Board suggested a 5-10% increase in prices. But the Vice
President-Sales opposed it vehemently as he thought it would vitiate the image of the
firm as a low cost high quality producer. He said this could result in an erosion of the
company’s customer base.
A high level team was constituted to look into the problems in the firm.
Questions:
1. Prepare a report listing what should be done by the company to effect a turnaround.
Forecasting 103
2. What reports should the management receive on a regular basis to prevent a
recurrence of such events in future?
Notes

Unit 8: Materials Requirement Planning

Notes
Structure
8.1 Introduction
8.2 Overview of MRP System
8.3 Purpose of MRP
8.4 Requirement of MRP
8.5 Materials Planning Process
8.6 Bills of Material
8.7 Lead Time Determination
8.8 Lead Time offset
8.9 Aggregation of Demand
8.9.1 Aggregating Demand Means
8.9.2 Demand Aggregation Module Capabilities
8.10 Level By Level Exploration
8.11 Time Fences
8.12 Mrp Output
8.13 Supplier Scheduling
8.14 Summary
8.16 Questions And Exercises
8.17 Key Terms
Objectives
z Define material requirement planning
z Explain purpose and requirement of MRP
z Describe lead time determination
z Discuss supplier scheduling
8.1 Introduction
Material requirements planning or MRP is a time-phased priority planning system. This
system calculates the requirements of the materials and schedules supply to meet the
demand pattern that follows.
The usual question asked in Inventory Management is how much of the stock is to
be carried and when is it to be carried? In all our Inventory models we learn of Lot
Sizing and the techniques like EOQ give us the answer regarding the quantity to be
purchased. Getting the right material, at the right place and at the right time can
generate very significant results even though the lot size has not been computed
scientifically. Getting the right quantity at the wrong time, does not accomplish much.

Materials Requirement Planning 105
Timing of the purchase is a very important factor, specially when the materials are
interdependent. For example, one may have all the raw materials needed to
manufacture the product, but still may go out of stock for packaging materials. This is Notes
true in case of assemblies and sub- assemblies also.
The question, ‘when to order’ is also very important in purchase management?
Usually this depends upon lead-time of the supplier. The organisation should have
adequate stock to cover the lead-time of the supplier. One also keeps extra stock for
any variation in lead-time and by calculating lead time stocks and the extra stock for
lead time variations, reorder level point is fixed. Such order point approach is the
conventional method of determining when to order.
However, MRP uses a slightly different method in handling the problem of ordering.
The order point system assumes that each item in the inventory is independent of all
other items and can be ordered independently. MRP as originally used was a way to
calculate parts requirement for assembled products. MRP treats items as if their
priorities are dependent and it calculates future demands. The three prerequisite inputs
for making MRP work clearly are as follows:
(a) MPS (Master Production Schedule) – What is planned?
(b) BOM (Bill of Material) – How it is done?
(c) Inventory Status – What has been done?
With these three inputs, MRP can determine what needs to be done in terms of
What, How Much and When.
8.2 Overview of MRP System

The following is an overview of the MRP system.
(a) Master Production Schedule: The Master Production Schedule expresses the
overall plan of production. It is stated in terms of end items which may be either
products or highest level assemblies from which these products are eventually built
in various configurations, according to the final assembly schedule. The span of
time, the Master Plan Schedule covers, called the Planning Horizons, is related to
the cumulative procurement and manufacture lead time for components of products
in question.
(b) Product Structure File or Bills of Material File: This contains information on the
relationship of components and assemblies which are essential to the correct
development of gross and net requirement.
(c) Inventory Record File: Also called the Master File, this comprises the individual
item-wise inventory Records, containing the status data required for the
determination of the net requirement. All this information is fed to MRP system and
the system will generate what action is to be taken and what needs to be done in
respect of various materials required at different points of time.
MRP LOGIC
The Logic of MRP is given by the simple arithmetic equation.
X = (A × B) – C
Where A = Master Production Schedule Quantities
B = Bill of Material Quantities
C = Inventory Quantities
X = Action needed
From the above equation it is found that in order to have an accurate MRP
system, everything depends on the people who maintain the system. A high level

of accuracy is required to maintain MPS, Bill of Material and Inventory Records and
people have to take required action.
Notes
8.3 Purpose of MRP
Nowadays, manufacturers are increasingly subject to massive pressures to drive down
costs and increase efficiency. However, these pressures often invalidate the traditional
Materials Requirements Planning (MRP) approaches. Moreover, companies struggling
to serve their customers using purely traditional MRP methodology are often unable to
meet the demands for agility and responsiveness that consumers at the end of the
supply chain are requesting. To make things worse, with product life-styles decreasing,
it means that manufacturing and distribution are increasing in complexity.
For the manufacturer, this translates into a need to better manage customer
demands and expectations, and to respond accordingly. MRP has accordingly been
redefined. The new concept is MRP II—it stands for Manufacturing Resource Planning.
MRP II is also the basis of Enterprise Resource Planning (ERP). Both MRP II and
ERP are concerned with the manufacturing aspects of the expanded model. These
include conventional Material Requirements Planning and scheduling. They are
integrated into purchasing functions, sales order, costing, accounts receivable and
payable, general ledger, etc.
Material Requirements Planning and scheduling have seen a lot of change over the
last two decades. Gary Barton, partner at Deloitte Touche Consulting Group (San
Francisco, CA), explains the Master Production Schedule (MPS) assumes static
requirements and it schedules existing capacity. "But, it's not enough for marketing and
sales to give us a plan of demand once a month and then for us to cycle through the
traditional requirements planning each week. By the middle of the week, the
requirements plan that we put in place is usually busted. Our ability to predict is only so
good". New systems to overcome these limitations are being developed.
The business environment today is complex with uncertainties, competition and
change. To be competitive, an enterprise should have good processes and systems,
which should be able to adjust to the changes in the business environment. The change
can be of technological innovations, government policies, interest rates, competition,
changing customer perception and many other fluctuating forces.
To achieve competitive advantage companies differentiate themselves from other
players in the market. There are various ways by which a company can do so.
z The products that are going to be produced should conform to the requirements of
the market and the design should be such that it should forecast and accommodate
customer's future needs.
z The marketing department, which keeps an eye on the trends and needs of the
market, should give relevant information to the production department so that they
would make periodic and relevant changes to the products.
z The demand-supply factor in the market should be analyzed for proper production
planning and there should be some system that can assist management to take
strategic decisions.
z Competitive advantage starts from sourcing the right raw material at the right time.
For this, the organization should have a good system of managing its vendors,
which includes parameters of quality, price and delivery schedules.
z Manufacturing inventory system should be optimum, which is essential in achieving
the first stage of the cost reduction process.
The function of a manufacturing inventory system is to translate the Master
Production Schedule into detailed component material requirements and orders, based
on inventory. The system determines item-by-item, what is to be processed and when,
as well as what is to be manufactured and when. This is based on order priorities and

available capacities. As the purpose of manufacturing inventory is to satisfy production
requirements, the production plan is the source of demand and thus the demand is
deterministic. Notes
From the point of view of quantity and timing of related production planning systems,
four categories of systems are possible to manage and control inventories.
1. Statistical Order Point: The system provides optimal solutions by means of standard
solutions to standard situations using statistical information to calculate optimal item
parameters, e.g., automatic recalculation of lead times, economic order quantities
and reorder points.
2. Lot Requirement Planning: An order method that is driven by forecast periods.
Order quantities are made to match demand in each specific forecast period.
3. Time Phased Order Point: Time-phased replenishment relies on actual demand –
not established stock levels – to drive the ordering and quantities of inventory for
manufacture or distribution.
4. Material Requirements Planning: A Material Requirements Planning system,
narrowly defined, consists of a set of logically related procedures, decision rules
and records, designed to translate a Master Production Schedule into net
requirements and the planned coverage of such requirements, for each component
inventory item needed to implement this schedule.
8.4 Requirement of MRP

Having learnt the basic concepts of MRP, let us now find out what are the Three Pre-
requisite Inputs for making MRP work. They are:
1. Master Production Schedule (MPS)
2. Bill of Materials (BOM)
3. Inventory Records File
We will examine each of them now.
1. Master Production Schedule (MPS): The development of an aggregate plan
leading to the Master Production Schedule is the starting point for a detailed MRP
system.
Formulation of an Aggregate Plan is the starting point and is based on the
expected receipt of a certain number of orders for a given family of products during
the planning period. Various forecasting techniques (such as judgemental, time
series analysis, exponential smoothing techniques, regression and correlation
analysis, etc.) are used to determine an approximate aggregate demand for the
product family. The Plan must be firmed up for a reasonable period of time because
overall production volume cannot be changed abruptly without incurring significant
unplanned costs. Every production volume utilises a given mix of labour, materials
and equipment. When the output rate is changed, a new optimal mix must be
achieved by readjusting the usage rate of the various resources. Even though it is
possible to change in the long run, in the short run, it is difficult to do it efficiently.
The Master Production Schedule is derived directly from the Aggregate Plan. It
translates the Aggregate Plan into specific numbers of specific products to be
produced in identified time periods.
The example below illustrates the difference between the Aggregate Plan and
Master Production Schedule for a car manufacturing company:
Aggregate Plan
Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
No. of cars 70 80 80 60 55 52 55 60 70 70 75 75
Master Production Schedule (for producing the cars)

Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Model A 30 30 25 20 20 25 20 25 25 25 25
Notes Model B
Model C 15 15 20 10 10 10 10 15 15 15 20 20
The time interval used in MPS varies from firm to firm. It depends on the type of
products used, the volume of production and the lead times of the materials used.
This span of time that the MPS covers is called the Planning Horizon.
Typically, within the framework of a six to twelve month Aggregate Plan, the Master
Production Schedule is updated weekly to reflect changing sales demand and also
the internal problems, which require scheduling.
2. Bill of Materials (BOM): The list of all the materials and their quantities required to
manufacture an item is called the Bill of Materials. This is used for calculating the
specific material requirements for a given production schedule during a specific time
period.
The BOM file is also called the Product Structure File or Product Tree because it
shows how a product is put together. It contains the information to identify each
item and the quantity used per unit of the item of which it is a part.
3. Inventory Records File: This comprises of the item-wise inventory records
indicating the item as well as the quantities in stock, besides a host of other
information. All this information, when fed to the MRP system, generates guidelines
on what action needs to be taken in respect of the various materials needed from
time to time.
8.5 MATERIALS PLANNING PROCESS

Before one goes through the planning process, we should list 5 MRP planning pre-
requisites,
(a) A valid master schedule that supports the production plan.
(b) Structure bill of materials that reflects the manufacturing process.
(c) Accurate and timely on hand and on order inventory status.
(d) Order policies.
(e) Lead time for purchasing and manufacturing parts.
The materials planning process comprises the following steps, which use the above
pre-requisites and determines the action required to balance supply and demand
for each part:
(a) To calculate gross requirements.
(b) To project the on hand inventory
(c) To reschedule open orders
(d) To plan new orders.
8.6 BILLS OF MATERIAL

The bill of materials is not simply a materials list but is a materials list that provides
information useful to reconstruct the manufacturing process. It serves as the interface to
order entry. The manufacturing bill of material is developed by re-sequencing the
engineering bill of materials in the context of the assembly process, and then deriving
from it the process information that will allow the new part to be ready for production.
While good business practice indicates that companies should aim for a unified set
of information, including having just one version of every bill of materials at a time, but
many different views of bills are feasible. Where good practice has not been fully
adopted, multiple concurrent bills of materials may be encountered. In addition to the

Manufacturing bill of materials and the engineering bill of materials, other possible and
common bills of material include:
1. Costing Bill of Materials: Occasionally encountered is a version of the bill of
Notes
materials, which expresses cost information separately from the manufacturing bill.
2. Planning or Modular Bill of Materials: This is used in Master Production
Scheduling. This is an artificial grouping of items in bill of materials format that
expresses the relationship of multiple product features, variants and options.
Inventory items are arranged in terms of product modules i.e. sets of component
items each of which can be planned as a group. The process of modularising
consists of breaking down the bills of highest-level item and rearranging them into
modules. There are two somewhat different objectives, in modularisation:
1. To disentangle combination of optimal product features.
2. To segregate common from unique, or peculiar parts.
The first is required to facilitate forecasting and the second is aimed at
minimizing inventories in components that are common to option alternatives, i.e.,
are used in either optional choice. Sometimes there are options within options (like
four-wheel or two-wheel drive for a jeep). A traditional approach to optional product
features was providing stock over the forecast provisions. The lack of
modularisation in product design made it difficult to disentangle options and options
within options, thereby entailing additional safety stock and making inventory
management more difficult.
A multitude of model designation implies that all the models, then get into the
processor of forecasting and master scheduling. It is difficult to forecast demand for
any single option, but to forecast, with a degree of dependability, and with what
other options it will be combined is very difficult. The number of models within each
product family should be reduced (at least for internal purposes). This is primarily
for procurement, fabrication and subassembly of components. For purposes of final
assembly scheduling, specific combinations of options must be specified for each
unit to be built. Thus the concept of modular bills of material is very useful in multi-
model product situations.
8.7 LEAD TIME DETERMINATION

In many production environments where demand and lead times are variable,
significant levels of safety stock inventory are required to assure timely production and
delivery of the final product. Traditional models to determine the appropriate safety
stock level may result in more safety stocks at sub-assembly and finished goods levels
than necessary and thus lead to higher inventory carrying costs than desired. Such
models generally incorrectly assume that the demand during the lead time follows a
normal distribution. A re-ordering point inventory model accounts for demand and lead
time variability without making any particular distributional assumptions. Instead, it
focuses on historical data to determine the possible outcomes of the replenishment
cycle. We compare the proposed model with the traditional model by conducting
simulation analysis using three data sets obtained from an electronics manufacturer.
The results indicate that the proposed model yields much closer to target service levels
and lower inventory carrying costs than the traditional model, regardless of the data set
used. In recent years, remanufacturing has emerged as an important research area,
due to the tendency of stricter environmental regulations in industry and the awakening
to the economic attraction of recovering the products rather than the disposal
alternative. This also requires developing manufacturing planning and control
techniques to improve the performance of remanufacturing systems. In order to
reassemble finished products, new components are required since the recovery rate of
return components can never reach 100%. When making a disassembly and
procurement decision, we then need to balance the inventory holding cost and stock out
cost. In the meantime, the process lead time depends on which disassembly a

procurement option that is chosen. A disassembly order is always released first and
then the disassembly result determines whether a purchasing order is needed.
Notes
8.8 LEAD TIME OFFSET
In materials planning, all components needed in a manufacturing job are usually
required to be available at a date equal to “the job’s due date, less the job’s overall lead
time”. However, all of the components may not be needed together right from the start -
for example, some may enter the production process part way through, after initial work
on the job has been started. If a component is not needed at the start, and it is very
expensive or it is in short supply, a lead time offset can be applied to it so that the
materials planning system does not call for it until an appropriate time after the job has
indeed started. A problem in practice with lead time offsets is that software writers fail to
provide a check at the start of the job as to whether a complete kit of parts is and will be
available. The parts with a lead time offset are not supposed to be present at the start of
the job, and may well be literally unavailable at the start. What the planner needs to
know is whether they will become available later when they are due.
In manufacturing, lead time is the assumed elapsed time from the point of entry of a
job into production to its completion and final emergence there from. It is normal to
consider manufacturing lead time as consisting of five separate elements: queue time
(time spent in queues waiting to begin); set-up (time to set the machine up for the job);
run (the time occupied by actual manufacture); wait (the time waiting after manufacture
has been completed); and move (the time spent moving the job to its next destination).
However, other elements might also be relevant in other environments - for example,
inspection time and tear down time. In whatever way it may be sliced, almost always in
the traditional job shop environment, 90% of lead time is found to comprise queue time.
Note that lead time in distribution has a completely different make up - for example,
order processing + packing & dispatch + transit time + order receipt + putting away.
8.9 AGGREGATION OF DEMAND

Demand Aggregation is a methodology that provides visibility into purchasing requests
throughout the enterprise generally through the process of coordinating and
consolidating requirements. The Demand Aggregation facilitates the various
departments or the companies of the enterprise to optimize the buying strength
resulting in high savings on the cost of direct and indirect goods as well as the services
using automated workflow and flexible Request for Quote (RFC) management. The
product demand across multiple plant locations, distribution channels or other units of
the enterprise is aggregated like items into a single purchasing request and ordered
from limited set of suppliers following standardized purchasing procedures.
Demand Aggregation supplies businesses with knowledge and visibility into the
purchasing requests throughout the entire company. It helps companies to increase
their purchasing power and obtain larger savings on the costs of goods and services.
8.9.1 Aggregating Demand Means

z Analysing historical purchasing data to provide the management information
necessary to assess purchasing practices and trends
z Drawing together information on common or similar current or future requirements –
within an organisation, and with other organisations
z Assessing the potential for collaborating with other business units within an
organisation, or with other organisations, and agreeing to present these
requirements in a coordinated way to the market.
Many companies achieve savings on the cost of goods by manually combining
purchase requests. This method is prone to errors, time-consuming, difficult to update,
and resource intensive. It also fails to provide visibility into enterprise-wide demand,
making it difficult to aggregate similar purchase requests. When multiple locations are

buying similar products and/or services, demand aggregation offers a great win-win
opportunity for buyers and suppliers. Buying organizations benefit from lower costs
through the economies of scale achieved by leveraging purchasing volume, dealing with Notes
fewer suppliers, and standardizing on fewer parts. Suppliers benefit by increasing their
strategic importance, lowering sales costs, and increasing manufacturing efficiencies.
The Demand Aggregation Module provides visibility into purchasing requests
throughout the enterprise and automates the process of coordinating and consolidating
requirements -allowing companies to maximize their buying power and achieve greater
savings on the cost of direct and indirect goods and services. Here’s how it works. First,
using automated workflow and flexible RFQ management, individual buyers create and
publish their sourcing needs. Once published, other buyers can be automatically
notified and invited to add their items to the request. Senior commodity managers can
review product demand across multiple plant locations or distribution channels,
automatically aggregate like items into a single purchasing request, and preserve a link
to the original requestor (for the delivery and billing of their portion of the consolidated
purchasing request). By identifying overlapping demand and consolidating it, category
managers can leverage purchasing volume to negotiate more favorable terms on both
price and non-price factors, including delivery, warranty periods, and desired
specifications. The purchasing organization can leverage information on overlapping
demand to consolidate parts and suppliers and reduce the effort associated with
managing multiple negotiations. Strategic suppliers benefit by competing for a larger
portion of the enterprise’s overall spend, reducing the cost of sales incurred when
responding to multiple requests, and improving operating efficiencies related to pooling
demand.
8.9.2 Demand Aggregation Module Capabilities

Maximize purchasing power by providing visibility into enterprise-wide demand and
automatically combining multiple purchase requests.
z Consolidate Overlapping Demand
z Streamline Buyer and Supplier Interaction
z Reduce the Cost of Complexity
8.10 LEVEL BY LEVEL EXPLORATION

When the bill of material is broken down in the process of modularisation, various sub-
assemblies are promoted and become end products, i.e., highest-level items. This
tends to create a large number of end items. In order to reduce the forecasting burden
the technique of creating pseudo bill of materials is used. The newly created end items
are grouped by option so that there is no obstacle to taking any such group and creating
a pseudo bill (assigning an artificial parent with a number) to cover it. The pseudo bill
number represents the optional product features in the MPS and MRP system will
explode the requirements from this point on.
With the emergence of cost effective data processing and MRP II and ERP
systems, it is possible to display the bill of materials in many ways. Commonly
encountered reporting formats include:
z Single-level Bill: A parent and its direct components.
Single-level where-used: An item and all the parents in which it is a direct
component.
z Indented Bill (multi-level bill): A parent, its direct components, their components
and so on down to the starting materials. This shows which components form part
of which parents at all levels.
Indented where-used: An item, all the parents in which it is a direct component,
their parents and so on up to the end products. This also shows structures.

z Next Level – End Level where-used: An item, all the parents in which it is a direct
component, and the top-level parents (products) of which they form part.
Notes z Summarized Bill: A list of all components (at all levels) in a parent with total
quantities, but not displaying any structure information.
The bill of material structure is the arrangement of inventory item data within the bill
of materials file. Information in the bill of materials includes:
z Item Identities: Assignment of item identity eliminates ambiguity and identifies
levels of manufacture. It cross-references the item master data. An item may be
able to be listed as a component more than once in a bill.
z Sequence Number: Can be used to present the bill in a particular way, grouping all
component items of a given type together, or presenting a picking sequence. Also
known as a 'find number' or 'balloon number'.
z Component Quantity: The amount of the component item to be used in
manufacturing the parent, normally stated as quantity per unit of the parent but
expressed per batch in some formula-based systems. Also known as 'quantity per'.
z Unit of Measure: May be provided automatically by an MRP II or ERP or other
system or specified by the user if unit conversions are available.
z Relationship: Indicates whether the component is used in the quantity stated per
unit or batch of the parent or in some other way, such as per order or as required.
z Type of Component: Shows whether the item is a normal component or a special
type. Types of component in addition to standard include phantoms, sometimes
called pseudo, options, reference items and others.
The bill of material should reflect, through its level structure, the way material flows
in and out of stock. Thus, it is expected to specify not only the composition of a
product but also the process stages in the product's manufacture. The product
structure must be defined in terms of levels of manufacture. Sub-assemblies which
never see a stock room because they are immediately consumed in the assembly
of their parents are called transient sub-assemblies.
8.11 TIME FENCES

Operations managers set various time intervals called time fences to regulate changes
in the MPS. Generally at least three time fences are fixed. For example, if three time
fences are fixed at time intervals of one, two, and three months, it would mean that the
MPS is not firm for periods of more than three months. The first time fence permits
product model changes provided the required components are available. During the
second time fence, changes are avoided though minor changes may still be permitted.
The last fence before actual production takes place is strictly frozen, i.e. no changes are
allowed during this time.
These projections help the production process to gear itself to meet its
commitments. Sharing this information with partners in the supply chain enhances their
ability to meet the customer's future needs accurately and economically and forges cost
effective supplier relationships.
Although the Master Production Schedule relates primarily to production, it has
significant direct implications for both marketing and finance. The schedule determines
whether or not the demand is met. There are marketing implications on the ability of the
organization to meet demand. Similarly, production generates significant costs in labour
and material, often reaching nearly 60 per cent of the total cash outlays. Consequently,
both marketing and finance must not just be aware of the master schedule, but must
also give it their approval.
MRP system assumes that the MPS understands in the 'part numbers', i.e.,
inventory item numbers that uniquely identify specific materials, component parts,
subassemblies and items. It is also assumed that each inventory item is unambiguously

identified through a unique code (part number). The bill of material lists the components
and their requirements for a given product and also reflects the way the product is
actually made-in steps from raw material to component part to sub-assembly to Notes
assembly to final product. There also has to be a system of inventory records for all
items under the systems control containing inventory status data and the planning
factors. A precondition for the system's effective operation is file data integrity pertaining
to inventory status data and to bill of materials data.
8.12 MRP OUTPUT

The common objective of all MRP systems is to determine (gross and net)
requirements, i.e. discrete period demands for each item of inventory, so as to be able
to generate information needed for correct action in ordering inventory, i.e. relating to
procurement and production. The action is either new action (release of an order) or a
revision of previous action. The essential data elements that are required for any action
to be taken are:
1. Item Identity (part number)
2. Order Quantity
3. Date of Order Release
4. Date of Order Completion (due date)
Once the order has been placed, the types of order action that are required when
revising an action taken previously, are limited to the following:
1. Increase in Order Quantity
2. Decrease in Order Quantity
3. Order cancellation
4. Advancement of Order Due Date
5. Deferment of Order Due Date
6. Order suspension (indefinite deferment)
MRP systems meet their objective by computing net requirement for each inventory
item. The term component in MRP covers all inventory items other than products or end
items. Requirements for end items are stated in the MPS. The latter are derived from
forecasts, customer orders, field warehouse requirements, interplant orders, etc.
Requirements for all component items (including raw material) and their timings are
derived from the MPS by the system.
After determining the net requirements, these are time phased to ensure their
proper coverage. Therefore, MRP converts the gross requirements into net
requirements. The net requirements are always related to time, i.e. to some date or
period. These are covered by planned orders. Their quantities and timing are
determined by any of the lot sizing techniques. MRP signals, if necessary, the need to
reschedule any of these orders forward or backward in time, so that the net
requirements are directly related and are correctly timed with shop orders and purchase
orders. Capacity considerations are taken into account in determining MPS; this is not
the role determined by MRP.
All the inputs received above enable determination of correct inventory status of
each item under the control of MRP. The MPS expresses the overall production plan
and the span of time covered by it. This is termed the planning horizon. Item lead time,
safety stock (if any), scrap allowances, lot-sizing algorithms, etc. are available from the
inventory record file. This is used to determine the size and timing of the planned
orders. The product structure file contains information on relationships of components
and assemblies. The MRP system uses these inputs to provide a number of important
outputs. These outputs can be classified as primary and secondary outputs. The
primary outputs of an MRP system are:

1. Order-release Notices: These determine the orders that need to be placed and the
system makes the call for placement of planned order.
Notes 2. Rescheduling Notices: Based on the feedback from manufacturing, it firms up
requirements on open order due dates.
3. Cancellation Notices: Wherever necessary, it calls for cancellation or suspension
of open orders.
4. Item Status Analysis: It provides back-up data on the item. The output of the MRP
includes the following information: (a) Requirements, (b) Coverage of requirements,
and (c) Product structure.
5. Planned Orders: It identifies factors considered for planning and on that basis
schedules for releases of notices in the future.
The system is also capable of providing to provide a number of secondary outputs.
Apart from the primary outputs an MRP System can be used for:
(a) Inventory order action
(b) Re-planning order quantities
(c) Safeguarding priority integrity
(d) Performance control
(e) Reporting errors, incongruities and out-of-bounds situations in the system
Some of the secondary outputs that can be provided by the MRP system are:
1. Exception notices reporting errors, incongruities, and out-of-bound situations
2. Inventory level projections
3. Purchase commitment reports
4. Tracing demand sources
5. Performance reports
An MRP system that is properly designed, implemented and used will also contain valid
and timely information that can assist in the functioning of the organization on three
separate levels:
1. Planning and control of inventories
2. Planning of 'open order' priorities
3. Inputs to the capacity requirements planning system
8.13 SUPPLIER SCHEDULING

As we have seen, the very nature of MRP places the planner in close continuous
contact with material requirements and their changing schedules. When the schedule of
requirement changes, the supplier needs to be informed so as to change his delivery
schedules in line with the requirements. This is called Supplier Scheduling. Because of
the weekly updating of most MRP systems coupled with the frequent rescheduling that
often occurs' a supplier has to be very flexible. Careful cooperative planning is often
required, necessitating some compromise by both parties. Supplier reliability is a must.
The buying firm carries little inventory and there is less cushion in the system to handle
problems of late delivery, off-spec materials, etc.
Two concepts are generally in use:
1. Buyer-Planner Concept in which one individual, called the buyer-planner, handles
material requirements, develops material schedules, makes order quantity
determinations and handles all other activities related to the buying function. Thus,
he has an integrated role and maintains close contact with the suppliers.
2. Supplier Scheduler Concept in which the buyer handles all normal purchasing
responsibilities, except requirements releases against existing contracts. This is

handled by the planner; he becomes the buying firm’s supplier contact for all day-to-
day material scheduling matters.
Notes
Supplier selection is therefore a vital and critical aspect of an effective MRP system.
8.14 Summary
Material requirements planning or MRP is a time-phased priority planning system. This
system calculates the requirements of the materials and schedules supply to meet the
demand pattern that follows.MRP as originally used was a way to calculate parts
requirement for assembled products. MRP treats items as if their priorities are
dependent and it calculates future demands.
The span of time, the Master Plan Schedule covers, called the Planning Horizons,
is related to the cumulative procurement and manufacture lead time for components of
products in question. Nowadays, manufacturers are increasingly subject to massive
pressures to drive down costs and increase efficiency. However, these pressures often
invalidate the traditional Materials Requirements Planning (MRP) approaches.
Material Requirements Planning and scheduling have seen a lot of change over the
last two decades. Gary Barton, partner at Deloitte Touché Consulting Group (San
Francisco, CA), explains the Master Production Schedule (MPS) assumes static
requirements and it schedules existing capacity.
A Material Requirements Planning system, narrowly defined, consists of a set of
logically related procedures, decision rules and records, designed to translate a Master
Production Schedule into net requirements.
The Master Production Schedule is derived directly from the Aggregate Plan. It
translates the Aggregate Plan into specific numbers of specific products to be produced
in identified time periods. The bill of materials is not simply a materials list but is a
materials list that provides information useful to reconstruct the manufacturing process.
It serves as the interface to order entry.
In many production environments where demand and lead times are variable,
significant levels of safety stock inventory are required to assure timely production and
delivery of the final product. Operations managers set various time intervals called time
fences to regulate changes in the MPS. Generally at least three time fences are fixed.
Demand Aggregation is a methodology that provides visibility into purchasing
requests throughout the enterprise generally through the process of coordinating and
consolidating requirements.
MRP systems meet their objective by computing net requirement for each inventory
item. The term component in MRP covers all inventory items other than products or end
items. An MRP system that is properly designed, implemented and used will also
contain valid and timely information that can assist in the functioning of the organization
on three separate levels.

1. The _________________ Schedule expresses the overall plan of production.
(a) Supplier
(b) Planned Order
(c) Inventory Record
(d) Master Production
2. ________ uses a slightly different method in handling the problem of ordering.
(a) MRP

(b) EOQ
(c) JIT
Notes
(d) ABC
3. MRP treats items as if their priorities are dependent and it calculates future
___________.
(a) Supplies
(b) Demands
(c) Output
(d) Input
4. The list of all the materials and their quantities required to manufacture an item is
called the _______________.
(a) Bills of Material
(b) Supply Schedule
(c) Summarized Bill
(d) Single level Bill
5. Every production volume utilises a given mix of ___________, materials and
equipment.
(a) Labour
(b) Tools
(c) Investment
(d) Spares
6. The BOM file is also called the ________________ because it shows how a
product is put together.
(a) Inventory Tree
(b) Product Tree
(c) MRP Tree
7. In manufacturing, _____________ is the assumed elapsed time from the point of
entry of a job into production to its completion and final emergence there from.
(a) Lead Time
(b) Product Level
(c) Bills of Material
(d) Product Tree
8. The product structure file contains information on ______________ of components
and assemblies.
(a) Types
(b) Level
(c) Scenario
(d) Relationships
9. Operations managers set various time intervals called ____________ to regulate
changes in the MPS.
(a) Time fences
(b) Time slot
(c) Time Frame
(d) None of these

10. MRP system assumes that the _________ understands in the 'part numbers'
(a) MPS
Notes
(b) EPS
(c) VAS

1. What is the purpose of MRP?
2. Discuss requirement of an MRP system.
3. How lead time is determined?
4. Explain utility of time fences.
5. What is supplier scheduling?
6. What is lead time offset?
7. What are the primary outputs of any MRP system?
8. Explain in detail bills of material.
8.17 Key Terms

z MRP: Material requirements planning or MRP is a time-phased priority planning
system. This system calculates the requirements of the materials and schedules
supply to meet the demand pattern that follows.
z Bills of Material: The list of all the materials and their quantities required to
manufacture an item is called the Bill of Materials. This is used for calculating the
specific material requirements for a given production schedule during a specific time
period.
z Lead Time Determination: It focuses on historical data to determine the possible
outcomes of the replenishment cycle.
z Time Fence: Operations managers set various time intervals called time fences to
regulate changes in the MPS. Generally at least three time fences are fixed.
z Supplier Scheduling: The very nature of MRP places the planner in close
continuous contact with material requirements and their changing schedules. When
the schedule of requirement changes, the supplier needs to be informed so as to
change his delivery schedules in line with the requirements. This is called the
Supplier scheduling.

1. (d) Master Production
2. (a) MRP
3. (b) Demand
4. (a) Bills of Material
5. (a) Labour
6. (b) Product Tree
7. (a) Lead time
8. (d) Relationships
9. (a) Time Fences
10. (a) MPS


Notes
New Delhi
CASE STUDY: Implementation of Materials Requirements Planning

M/s Indiana Electronics is a small firm located at Bhiwadi near Gurgaon. Its major
product line is the electronic system for automobiles and M/s Maruti Udyog Ltd.
Gurgaon is its major customer.
With competition getting tougher for M/s Maruti Udyog Ltd., they are forced to
contain the prices of all their raw materials. So, M/s Indiana Electronics too cannot
escape and have to give a cost reduction consistently to M/s Maruti Udyog Ltd.
The top management of M/s Indiana Electronics decided that the firm is ideally
suited to implement MRP in its planning and controls. Several organisation changes
were brought about. A Materials Management Department was created to include
purchasing, production control, traffic, inventory management and warehousing
operations. The implementation and effective operation of an MRP system came within
its purview.
Another change brought about was the Buyer-Planner concept, i.e. an MM
executive would be responsible for both buying and planning functions. The number of
materials handled by each executive had been reduced but the scope of work of each
executive had become large and more integrated. For a given group of materials, a
single executive would prepare the production schedule and work directly with suppliers
to make it function properly.
All the systems in M/s Indiana Electronics are computerised. Whenever a new
executive is hired, he or she is required to develop and manage the plan for one or two
items, MANUALLY. The idea is to teach the newcomer how the system works.
Mr Singh is the latest newcomer to the company. On the second day, he was given
the Master Production Schedule for Component A as follows:
Order Quantity – 120 units, Lead time – 3 weeks, Safety Stock – 50 units
Time period in weeks
1 2 3 4 5 6 7 8
Requirement FIRM 30 40 35 45 55 40
Requirement TENTATIVE
Expected receipt
Questions:
1. Help Mr Singh in calculating the planned order releases to be commensurate with
requirements.
2. Narrate the changes caused in M/S Indiana Electronics through the implementation
of MRP.

Introduction to Merchandise Management 119
Unit 9: Spare Parts Inventory

Notes
Structure
9.1 Introduction
9.2 Definition of Spare Part
9.3 Need For Spare Parts Inventory
9.4 Classification of Spare Parts
9.4.1 Usage Rate
9.4.2 Functional Characteristics of Spare Parts
9.5 Stocking policies for different classification of spares
9.6 Reconditioning and Overhauling Policies
9.7 Determination of Optimum Number of Spares – Problems and Solutions
9.8 Summary
9.11 Key Terms
Objectives
Define spare parts inventories
Define and describe the features of spare parts inventory
Describe factors influencing stocking of spare parts inventory
Classify spare parts inventory
Explain the steps for management of spare parts inventory
9.1 Introduction
We have so far discussed various aspects of Goods in Transit, Production Materials,
Work-In-Process and Stock-In-Trade (Finished Goods) Inventories. The perspective
has been that of a Manufacturing Organisation. It is now time to move over to the
perspective of the customer of the Finished Goods. In so far as consumables are
concerned, these are either consumed immediately on being bought or at the most
stored for short periods. The former is a JIT situation with no inventory and the latter is
a case of short term inventory management which is easily executed keeping in mind
the storage space available, the logistics effort and sometimes the financial constraints.
The case of consumer durables is a bit more complicated, because items like cars,
refrigerators, washing machines, food mixers, etc. are used for several years and need
to be maintained and some parts need replacement when they don’t work due to fair
wear and tear. Such replacements, subject to certain exceptions, are replaced free by
the seller during the warranty period, after which they have to be paid for. Even after the
warranty period, the customer does not keep an inventory of such parts, except for
parts like a fan belt, lamps, fuses or radiator hoses which a car user may carry, when he
is undertaking a long journey.
Plant, Machinery, Power Generating Equipment, Fleets of
cars/trucks/tractors/aircraft/ships ,etc., Products of Heavy Industry and the like, need to

be maintained for much longer periods of their life-times than consumer durables and
are more intensively used, some of them round-the-clock for years together. Their parts
Notes wear out much faster and they need to be periodically ‘overhauled’ when many major
assemblies are replaced irrespective of their condition. Inventory management of spare
parts in such organisations/users is a special subject itself and will be discussed in this
chapter.
Spare parts management calls for special attention. It has become critical and is
one of the specialised areas of management of production assets of the organisation.
This is due to multiplicity of designs and makes of machinery. Hence spare parts
management deserves special consideration. Further, in the context of competitive
survival the Industry is expected to utilise its production assets in an optimum manner.
With this back ground machines are working round the clock.
9.2 DEFINITION OF SPARE PART

Spare part means a part or sub-assembly or assembly for substitution, i.e. ready to
replace identical or similar part or sub-assembly or assembly, if it becomes faulty or
worn out and includes an accessory (or attachment) in the same regard.
Keeping the machines in fit condition calls for the right spare part at the right time,
in the right quantity. For any organisation, judicious use of production assets is a
primary objective.
Darwin’s theory of survival of the fittest will aptly apply here. The Company, which
has got fittest machinery, can survive in this competitive world of business. In the field
of materials management, raw materials, components and sub-assemblies are kept on
the basis of consumption. These inventories are maintained so long as it pays to keep
them.
When it comes to spare parts management – it is not same. Inventory management
is still nascent, and spare parts management is still more nascent. Spare parts
individually are trifles, whose shortages and non-availability will have much greater loss
disproportionate to their value.
Stringent economic conditions call for small level of inventory at the same time it
should not lead to ‘Stock Out’.
One thing that is certain in spare parts management is “its uncertainty”.
Spare parts are ironically defined as one which is available when it is not required
and not available when it is required.
9.3 NEED FOR SPARE PARTS INVENTORY

We know that a machine is made up of a large number of parts. Each and every part is
important for the smooth running of the machine. Even if one part fails or does not
function properly, the machine will fail or not function to its full capacity. Some parts
never fail during the lifetime of a machine, whereas some parts fail frequently. Some
other parts fail only once in a while. There are also parts that wear out over a period of
time and create some problems, which if not attended to and corrected, would result in
jerks or vibrations in the machine. This may result in early failures of say, coupling bolts,
or may even result in cracks in the body of the gear box, thus forcing replacement of the
gear box itself.
All these parts referred above are called Spare Parts. We can now define Spare
Parts as “Parts identical to the parts of a machine/equipment that needs replacement
due to wear and tear or breakage during the operating life of the machine/equipment”.
They should never be mixed up with raw materials – raw materials and consumables
are used directly in production, but spares are not directly used in production.
The need for spare parts inventory is due to the following factors:

1. Nature of Items: In case of imported spare parts, the need for storing increases
because of the long time required for various import formalities and customs
clearance procedures. Opening of Letter of Credit in case payment terms are Notes
through Letter of Credit takes time. Similarly, legalisation of documents through
Chamber of Commerce or Consulate Office, etc. takes time before the spares can
be made available. In case of heavy items, shipment is normally done through sea
freight, which involves long delays and greatly depends on the route of the ship and
weather conditions affecting the sailing of the ship.
2. Nature of Plant and Machinery: A highly sophisticated and mechanised plant is
vulnerable to breakdowns, which could be tackled by replacement of
spares/components rather than repairs. The cost of downtime of these plants is
normally so high that spare parts in machines with a possibility of failure are to be
stored for immediate replacement of defective parts of plant and machinery.
3. Nearness of Dealer/Distributor/Service Centre: If local dealers/distributors are
close to the plant, the need for keeping the spares in the store is reduced. Similarly,
availability of service centres of the machines also influences spare part
requirements. Spare parts which may not be required frequently, but are critical for
operations, may not be stored any longer as the same will be available in the
service centre. The risk of long downtime of the machine due to non-availability of
the spare will no longer be there.
4. Technical Evaluation of Machine before Purchase: One of the very important
factors in spare part management is the technical evaluation of the machine from
the point of view of maintainability and reliability, before its selection for purchase.
One examines the design aspects, operating parameters and considers the
operating conditions of the machine. Some of the machines may be more prone to
failures, and will therefore require more spares. Electronic controls in place of
mechanical controls may have less moving parts and therefore will need fewer
repairs. The initial cost of these machines may be higher but their higher uptime
and lower need for replacement of parts may pay off more than the high initial cost.
5. Appropriate Maintenance Techniques: The predictive maintenance approach has
greatly affected the management of spare parts. There is no need to stock an item
until it is required and this can be known well in advance. Stoppage of a machine
upon failure of a part results in loss of machine hours and necessitates emergency
purchase of spares, which are procured at a very high price as compared to the
price paid when procured in normal circumstances in a regular activity. In normal
purchase, there is enough time to identify the right source for obtaining the best
prices, negotiating best prices, consolidating shipments and saving on
transportation costs. It also helps to purchase items from the Original Equipment
Manufacturer (OEM) of the item rather than to purchase it from others, who often
charge very high rates.
6. Failure Analysis: It is often very difficult to predict when a part will fail and whether it
will fail or not. The past experience of the maintenance staff and their judgment
plays an important role in maintaining the machine in operating condition by proper
forecasting and planning of the spares in advance. It is often observed that in the
early years of operation, the health of the machine is good and replacement of parts
is not required very often. As the machine grows older, its various parts undergo
wear and tear and thus there is a greater need of the spare parts for replacement.
This calls for scientific method of planning the quantity of spare parts rather than
depending on mere judgment.
History sheets record the full details of maintenance activities carried out, parts
replaced, conditions of each part and data of important parameters such as
vibration level, clearance between bearing and casing, temperature, oil condition,
etc. Failure analysis is based on a scientific approach. The frequency of failure of
parts, life yielded by important components and the details of the conditions of parts
help in predicting the possibilities of failure and therefore in projecting the future
requirement of spares. Many manufactures have begun to furnish preventive

maintenance schedules which can eliminate or greatly reduce guesswork/analysis

by the Works Engineering Team.
Notes 7. Administrative Factors: Various administrative factors such as organisation
structure, procedures to be followed, storage facilities and records have a bearing
on the spares to be stocked.
(a) Organisation Structure: Some very large organisations may have multi-point
stocking and some may follow single-point stocking with all the units linked with
computers so that they can know the stock of items as and when they need.
Concepts of centralisation and decentralisation of inventory control also greatly
influence spare parts management.
(b) Procedures Followed: Very long clerical procedures involved in decision
making, long documentation and wasting time on minor issues influence the stock
level of spares. Inventory level can be reduced to a great extent if the system is
efficient and response time is low. Computerisation of MM and linking the suppliers
in the network helps in obtaining quotes for the items, information on availability of
stock, etc. and helps in cutting down the procurement time.
(c) Storage Procedures: Procedures for stocking items systematically and a very
well laid out procedure for issuing items from the stores greatly helps in spare parts
management. Difficulty in location of an item in the store is not uncommon. Also,
issue procedures are sometimes so cumbersome that the Maintenance Department
may keep some stock with them thus leading to one more stocking point and
therefore duplication of stock.
(d) Record Maintenance: It is often seen that where record keeping is not given
much importance and is delegated to the lower levels of the hierarchy, anomaly
exists between the actual stock and the record books. Items that are physically
available may not be found in the record and this will prompt fresh procurement.
The opposite is equally dangerous. Items available in the record books may not be
available physically. This will delay the process of procurement and will lead to
stock outs and its resulting problems.
8. Financial Factors: Various financial factors influence the management of spare
parts such as – inventory carrying costs, stock out costs and cash availability.
9.4 CLASSIFICATION OF SPARE PARTS

Spare parts can be classified broadly on the basis of
(a) Usage rate
(b) Functional characteristics of spare parts
9.4.1 Usage Rate

Accordingly to usage, spare parts can be of two types based on consumption:
(i) Regularly used Spare Parts: These are certain parts in a machine which have a
life less than the machine as a whole but may have to be replaced at least once,
perhaps several times, during period of operating life of machine.
For example, Standard ball bearings, gears, valves, gaskets, seals etc.
(ii) Irregularly used Spare Parts: These are certain parts of machine that have life
which in most cases is same or longer than that of the machine. When the
machines are scrapped, the parts in the machine will still be in satisfactory
condition. However, some of these may fail in a random manner. For example,
Crank case of an engine.
The former can also be classified on the basis of movement analysis:
Fast-moving: Items which have moved at least once in one to two years are
classified as fast moving.

Slow-moving: Item which have not moved at least once in a period of two to four
years.
Non-moving: Items which have not moved even once in five years duration are
Notes
classified as non-moving.
(Note: The cut-off periods could be changed according to the requirements of the
individual organisations).
9.4.2 Functional Characteristics of Spare Parts

The general classification of spare parts based on following functional characteristics:
1. Capital Spares: Capital spares are the functioning parts of the mother equipment
or machine whose life is almost the same as the machine.
2. Insurance Spares: Like capital spares, insurance spares too are the functioning
parts of the mother equipment or machine whose life is almost the same as the
machine.
3. Rotable Spares: Rotable spares are those which can be repaired and reused.
4. Maintenance Spares: Spares that are regularly consumed during the use or
operation of the machine are called maintenance spares
5. Overhauling Spares: Overhauling is a detailed thorough checkup undertaken
periodically to impart a new lease of life to a machine.
9.5 Stocking policies for different classification of spares

Following are the different policies used for different classified spares.
1. Capital Spares: Capital spares are the functioning parts of the mother equipment
or machine whose life is almost the same as the machine. They do not generally fail
during the life of the machine under normal circumstances. But if they fail, the
losses would be phenomenal. Hence these spares are usually procured along with
the mother equipment as per the advice of the suppliers of the mother equipment.
The fact that capital spares have to be carried by organisations is beyond doubt.
How much to carry is the only question materials managers ask.
2. Insurance Spares: Like capital spares, insurance spares too are the functioning
parts of the mother equipment or machine whose life is almost the same as the
machine. They too, do not generally fail during the life of the machine under normal
circumstances. But if they fail, the losses are very high. They are also procured
along with the mother equipment as per the advice of the suppliers of the mother
equipment. The difference between capital spares and insurance spares is that
while reliability of insurance spares is almost 99%, the reliability of capital spares is
around 95%. Classification of spares to insurance spares is often a matter of debate
amongst Materials Managers of the organisation.
A State Electricity Board has been carrying ` 2 crores worth of insurance
spares during the last 15 years and nobody would take the risk of declaring them as
obsolete because of the “dreadful consequences”. Many of the process plants also
adopt a conservative policy with regard to insurance spare parts as they feel that
the consequences of under stocking these spares are indeed substantial. The
policy for insurance spares in many organisations is based on the number of
installed machines requiring these spares, estimated life, lead time, availability
considerations, etc. Depending on these considerations, the amount of insurance
spares is invariably carried.
3. Rotable Spares: Rotable spares are those which can be repaired and reused.
They can be interchanged. Rotors, pumps, engines, compressors, motors, etc. fall
under this category. The faulty part can be removed and repaired and stored for
future use. It can then be fitted as and when necessary.

Rotable spares are generally expensive with a long lead time of procurement
since they have to be made-to-order. The stocks out costs are also high.
Notes 4. Maintenance Spares: Spares that are regularly consumed during the use or
operation of the machine are called maintenance spares. These spares usually
wear out due to constant use. Pipe fittings, gaskets, valves, switches, V-belts, etc.
fall in this category.
Compared to other categories of spares, these are fast moving, requirement is
repetitive in nature and they are relatively cheaper. These parts are easily
accessible for replacement without having to strip or open the machine. Their rate
of consumption is usually not erratic, hence it is possible to establish consumption
patterns, fix order quantities, frequency of replacement and safety levels.
5. Overhauling Spares: Overhauling is a detailed thorough checkup undertaken
periodically to impart a new lease of life to a machine. Organisations undertake
periodic overhaul of machines on a planned and scheduled basis after pre-
determined number of hours of working. Overhauling is not to be confused with
ordinary repair, which is not planned and takes place upon failure.
The spares required during such overhauling activity are called overhauling
spares. These spares can be classified into three categories:
(a) Mandatory Spares: These are spares that have been recommended by the
manufacturer to be replaced during overhauling, irrespective of the condition of
the spare. Since their replacement is pre-planned, inventory planning is very
easy.
(b) Non-mandatory Spares: These are spares that have been found to be requiring
replacement in 10% to 90% of the rotables, which have been overhauled in the
past.
(c) Insurance Spares: These are spares that have been found to be requiring
replacement in less than 10% of the rotables, which have been overhauled in
the past. In order to identify the non-mandatory and insurance spares a “Ten-
off” list is usually prepared wherein the spares are categorised and graded from
1 to 10. A decision is then taken that say, quantities of grade 1 will fall under
insurance spares, 2 to 9 under non-mandatory spares and 10 as mandatory
spares.
9.6 Reconditioning and Overhauling Policies

Reconditioning and overhauling of spares is often resorted to, in order to maximise the
returns on investment. Reconditioned or overhauled items are almost as good as the
new items and can yield almost the same life as a new item. In deciding whether to go
for reconditioning or not, the cost of reconditioning is compared with the cost of the new
item as well as the life that the reconditioned item will offer. For example, if the cost of
reconditioning an item is about 70% the cost of a new item and it will give a life of about
60% of the new item, then obviously there is no point in going for reconditioning.
Items commonly reconditioned and used are rolls, conveyor belts, tyres, etc. In
case of high value items such as rolls, reconditioning facility is often set up within the
plant itself and a team of trained personnel is developed for repairing and
reconditioning.
The Government of India, with a view to contain the heavy inflation witnessed in the
economy in the early 70s, implemented the Tandon Committee proposals from the
middle of 1975. These proposals were exhaustive and called for inter-alia changes in
the philosophy of lending, new inventory norms and a package of financial information
from the borrower. However, it did nothing explicitly with regard to the machinery spare
parts. In fact the Committee recommended that the banker should keep a watchful eye
if the spare parts inventory value exceeds 5% of the total inventory value! The norms
were laid without any differentiation with regard to the nature of the industries.

On the other hand, the management of spares-intensive industries like refineries,
fertiliser plants, steel plants and Electricity Boards have been taking steps to maximise
production and minimise breakdown through continuous supply of essential spare parts Notes
with adequate investment in spares inventory. In fact the management of these capital
intensive industries (bulk of which is in the public sector) is too anxious to keep the
downtime at a minimum level and hence conservative policies are practiced in the of
initial provisioning of spare parts, subsequent ordering, stocking, etc. This was
considered necessary as any slowdown in these critical sectors would have
repercussions on the entire economy, as these are the basic inputs to almost every
industry.
As common with any developing country, India has also sought technical expertise
from many advanced countries. Transfer of technology has taken place from a plethora
of countries – we have steel plants built with Russian, German and British
Collaboration, State Electricity Boards operating several power stations with
equipments from many countries, etc. This situation exists in many other industries in
India. Therefore, interchangeability of vital and costly spares has become virtually
impossible, leading to a wasteful accumulation of spare parts inventory.
Rapid technological strides have taken place in developed countries and the spare
parts are no longer manufactured by the original equipment manufacturer, having
become obsolete there. The Indian industry on the other hand, is forced to play safe at
the time of initial provisioning and stock in advance, or else it has to face the
unreasonably high lead time price at a later stage. These factors have led to carrying a
high degree of obsolete spare parts in the Indian economy.
9.7 Determination of Optimum Number of Spares –

Problems and Solutions
Much debate has taken place on this issue and needless to say, no unanimity has been
reached. Several researches have been carried out within industry as well as across
industries. One mining organisation was found to carry 12 years requirement as
inventory. This organisation, which has its units spread all over the country has
landed itself in this situation owing to the individual units provisioning on a piece meal
basis independently, without any coordination at the headquarter level, although a great
deal of interchangeability existed between the units. One State Agro industrial
corporation carries over one crore rupees worth of spare parts inventory for their earth
moving equipments, whereas their annual consumption has never exceeded
` 15 lakh.
One battery manufacturing company set up recently with foreign collaboration has
provisioned for the next four years consumption, though it is aware that some of the
spares will never be needed in the future.
From the above, it is obvious that there cannot be one single norm for spares
holding across industries. Obviously, it will have to vary from industry to industry and
also from company to company. All cost-conscious companies have adopted policies
with regard to maintenance spare parts. These policies generally depend on the
consumption pattern and the estimation of the average life of the machine parts. Certain
minimum and maximum levels of inventory are also fixed depending upon the
availability and lead time considerations. For example, the norms for a company could
be – “Minimum level to be 6 times the average monthly consumption. Reorder level to
be 15 times the average monthly consumption. Maximum level would be minimum plus
reorder level. For imported items, the lead time would be 18 months and 9 months
would be taken as the indigenous lead time.”
It is to be appreciated that planning and provisioning for spare parts is most difficult
since spare parts failures are unpredictable, uncertain and occur owing to many
reasons such as poor maintenance, higher operating speeds, flaws in manufacturing,
flaws in operating practices, etc. Due to the problem of random pattern of failures,
inadequate availability of meaningful recorded data on failures, failures resulting from
more than one reason, long lead time both for imported as well as indigenous spares,
etc., it is very difficult to predict the exact norms for holding of spares. Many
Notes organisations are therefore forced to adopt conservative policies, which they hope to
improve after gaining sufficient experience.
Efficient procurement and availability of spare parts can be achieved by following
certain steps which are listed below:
1. Prepare a List: A list of spare parts of each machine should be prepared and kept
ready at all times. The list should contain the complete information – the stock
number, description, quantity required and available, suppliers name, address, code
number, etc. and should have a link with the mother equipment in the computer
system, so as to be able to identify which mother equipment the spare belongs to.
2. Complete Specification: The specifications should describe in detail the part, its
manufacturer, the mother equipment and its manufacturer, model numbers, if any. If
any drawings are available, it is most important to mention the same in the
specification, along with the drawing serial numbers/place of storage.
3. Analysis of Spare Parts: As we have read with respect to inventory in the previous
chapters, analysis of spares is equally important and should be done in the same
manner. After all, some spares are more important than others.
The ABC Analysis based on annual consumption, VED analysis based on the
importance of the items to the Plant Operations, FSN analysis based on the rate of
consumption and XYZ analysis based on the stock value are all very commonly
used. Other classifications such as SDE, GOLF, SOS and HML have all been
explained in the previous chapters. Matrices of two or more methods can also be
used for analysis of spares.
4. Periodic Review: The spares should be reviewed at regular intervals, the
frequency of review being fixed by the management. The review should
include – the spares purchased since the last review, the spares consumed during
that period, spares failed, the reason for failures, life yielded by a spare, etc. The
reviewing group should also fix various measuring parameters such as vibration
measurements, measurement for shock pulse value of bearings, crack detention, oil
analysis, temperature measurement, etc. The maintenance department would carry
out these tests at periodic intervals and decide on the replacement of the spare
part.
5. Periodic Maintenance: Maintenance plays an important part in spare parts
management. Breakdown maintenance should be eliminated, and should be
replaced by preventive and predictive maintenance.
Preventive maintenance needs regular checks of the machines and its parts,
based on a Standard Operative Practice (SOP) developed in advance. The
objective is to take corrective action before the machine stops and thus help in
reducing downtime of the machine.
9.8 Summary
In this chapter, we have learnt that accountability of materials does not begin and end
with the accounting of receipts, storage, preservation and issuance of materials only. It
starts with the planning of materials and includes sales and distribution, till the material
reaches the buyers after completing an entire integrated supply chain process.
Product life cycles are reducing day by day due to innovative push in technology.
Any laxity or compromise on the designs and specifications of an item may prove
disastrous in the marketability of the item. The accountability of such mistakes will have
to be borne by the materials manager alone.
In the public as well as private sector companies in India, it has been observed that
crores of rupees investments are locked up in the spares inventories due to faulty

planning and casual approach. Every effort is now being made to liquidate them and
prevent their recurrence.
Notes
Spare parts management is a very extensive area that is evolving every day. It is
universal to all organisations and researches and experiments will continue till the day
the reality matches with dreams. Spare parts management calls for special attention. It
has become critical and is one of the specialised areas of management of production
assets of the organisation.
Keeping the machines in fit condition calls for the right spare part at the right time,
in the right quantity. For any organisation, judicious use of production assets is a
primary objective. Various administrative factors such as organisation structure,
procedures to be followed, storage facilities and records have a bearing on the spares
to be stocked.
Reconditioning and overhauling of spares is often resorted to, in order to maximise
the returns on investment. Reconditioned or overhauled items are almost as good as
the new items and can yield almost the same life as a new item. Rapid technological
strides have taken place in developed countries and the spare parts are no longer
manufactured by the original equipment manufacturer, having become obsolete there.
The spares should be reviewed at regular intervals, the frequency of review being
fixed by the management. The review should include – the spares purchased since the
last review, the spares consumed during that period, spares failed, the reason for
failures, life yielded by a spare, etc.

1. _______________ management calls for special attention.
(a) Financial
(b) Spare Parts
(c) Strategic
(d) Logistics
2. One thing that is certain in spare parts management is “its __________”.
(a) Uncertainty
(b) Usability
(c) Accessibility
3. The ___________ maintenance approach has greatly affected the management of
spare parts.
(a) Predictive
(b) Spares
4. _______________ spares are the functioning parts of the mother equipment or
machine whose life is almost the same as the machine.
(a) Insurance
(b) Rotable
(c) Maintenance
(d) Capital

5. ______________ is a detailed thorough checkup undertaken periodically to impart

a new lease of life to a machine.
Notes (a) Overhauling
(b) Maintenance
(c) Capital
(d) Insurance
6. _______________ plays an important part in spare parts management.
(a) Maintenance
(b) Periodic Review
(c) Reconditioning
(d) Overhauling
7. Rotable spares are those which can be ____________ and reused.
(a) Repaired
(b) Purchased
(c) Labeled
(d) Classified
8. Spares that are regularly consumed during the use or operation of the machine are
called _____________ spares.
(a) Operational
(b) Maintenance
(c) Insurance
(d) Rotable
9. Matrices of two or more methods can also be used for ___________ of spares.
(a) Analysis
(b) Insurance
(c) Storage
(d) Overhauling
10. _______________ analysis is based on a scientific approach.
(a) Vendor
(b) Spares
(c) Inventory
(d) Failure

1. What are spares?
2. What are their special features?
3. What are the problems of spare parts management?
4. How are spare parts classified? Describe each of them along with examples.
5. Describe how the Materials Management of a large engineering company can
practice an effective control on their spare parts, with special emphasis on the
imported spares.
6. List some steps for management of spare parts.
7. What are the factors influencing the management of spare parts? Describe in detail.
8. Describe some of the commonly used methods for analysis of spare parts.

9. Distinguish between insurance spares and rotable spares.
9.11 Key Terms Notes

Spare Parts: Spare parts are parts identical to the parts of a machine/equipment
that needs replacement due to wear and tear or breakage during the operating life
of the machine/equipment.
Appropriate Maintenance Technique: The appropriate maintenance techniques
are needed in situations where stoppage of a machine upon failure of a part results
in loss of machine hours and necessitates emergency purchase of spares, which
are procured at a very high price as compared to the price paid when procured in
normal circumstances in a regular activity. Therefore, it is recommended to
purchase items from the Original Equipment Manufacturer(OEM) at negotiated
prices.
Failure Analysis: Failure analysis deals with the past experience of the
maintenance staff and their judgment which plays an important role in maintaining
the machine in operating condition by proper forecasting and planning of the spares
in advance.
Capital Spares: Capital spares are the functioning parts of the mother equipment
or machine whose life is almost the same as the machine.
Insurance Spares: Insurance spares are the functioning parts of the mother
equipment or machine whose life is almost the same as the machine.

1. (b) Spare Parts
2. (a) Uncertainty
3. (a) Predictive
4. (d) Capital
5. (a) Overhauling
6. (a) Maintenance
7. (a) Repaired
8. (b) Maintenance
9. (a) Analysis
10. (d) Failure

Gopalakrishnan P, Handbook of Materials Management, Prentice Hall of India
Narain Prahlad(2008). Inventory Management, Excel Books, New Delhi.
Reji Ismail, Logistics Management, Excel Books, Delhi.
Kachru Upendra (2007), Production and Operations Management, Excel Books,
New Delhi

Case Study
Notes
M/s Indiana Steels and Strips is a multi-location steel conglomerate with an annual
turnover exceeding Rs 10,000 crores. Their equipments are state-of-the-art highly
sophisticated and computerised machinery and they are into production of various sizes
and grades of high carbon and medium carbon steels in coil as well as bar forms.
M/s Indiana Steels has three steel plants- one built with German collaboration, one
with British collaboration and the third with Russian collaboration. Each of these plants
has the installed capacity to produce almost 1 million tons per annum. All the three
plants were commissioned within a span of 5 years.
At the time of installation of the plants, while buying the mother equipments, spares
that were recommended by the OEMs were also purchased. It was told to M/s Indiana
Steels that these spares are insurance in nature and would cover the requirement of the
next 3 to 5 years. M/s Indiana Steels did not question the logic and they did not also
have the necessary expertise to do the same. Hence spares amounting to 5-10% of the
equipment cost were purchased in each of the steel plants.
Ten years passed by. Purchases acquired the necessary importance in the
company and its contribution to profits was recognised. It was decided to represent the
function at the Board level and a Director Purchases was appointed. His brief was to
optimise procurement and contribute to making Indiana Steels a world class company.
After settling down, Director, Purchases began a probe. Amongst his findings, the
following were significant:
Spares account for 42% of the total inventory
Emergency purchases accounted for 10% of the total purchases and half of it were
spares
Capital and Insurance spares accounted for 9% of the total inventory. Most of them
were purchased at the time of purchase of the mother equipment. No drawings or
specifications were available for those spares
Spares could not be interchanged amongst plants because no two spares matched
even within the same group of items.
Many of the spares were imported and had a procurement lead time of 9 to 12
months
Many of the spares were proprietary in nature
The Maintenance Department was responsible for indenting of spares and they
would even suggest to whom the enquiries are to be sent. The Materials
Management Department never questioned anything – neither the quantities nor the
list of suppliers. After all, the loss of even one day’s production meant crores of
rupees lost!
Director, Purchase immediately realised that spares is one area he must attack
immediately to get results.
Give your suggestions to Director, Purchase for him to implement.

Stores Management 131
Unit 10: Stores Management

Notes
Structure
10.1 Introduction
10.2 Controlling Movement of Material
10.2.1 Custody
10.3 Activities in Warehouse
10.4 Warehouse Location and Acquisition
10.4.1 Macro Approaches
10.4.2 Micro approach
10.5 Warehouse Design and Layout
10.6 Material Handling and Equipment
10.6.1 Goals of Material Handling
10.6.2 Overview of Material Handling Equipment
10.6.3 Principles of Material Handling
10.6.4 Equipment & Systems
10.7 Record Keeping
10.8 Communications
10.9 Quality Standards
10.10 Summary
10.13 Key Terms
Objectives
z Understand all the activities in warehouse
z Discuss the material handling and equipment
z Explain the recordkeeping and communication.
10.1 Introduction
Stores management is a huge subject by itself and several books can be written on the
same. We would however, not go into depths and limit ourselves to a preliminary study
of the concept of warehousing since warehouse is the place where inventory is stored.
How a material is received, stored, retrieved and used has a great bearing on its
control.
In today's competitive manufacturing and business environment, the vital role of
warehousing has to be properly understood. The warehouse is a critical link between
the manufacturing plant and the external world and significantly affects the performance
of the entire manufacturing and logistics system. Systems in the warehouse need to be

integrated to the material supply chain, to realise the full benefits of supply chain
management.
Notes
Inventory represents a large percentage of the working capital in many organisations.
Minimising loss or damage makes a significant contribution to the overall profitability of
the business -- and is a key part of the stores function.
Important activities are:
z Collection of material from railways and road transporters
z Receiving material from transporters
z Preparation of receipt vouchers
z Recording of incoming material.
Materials received at the warehouse could be either delivered at the door of the
company by the suppliers or his agents, or collected by the company from the customs,
buyers’ premises or the transporters’ premises. In either case, before unloading, all the
receipt documents are to be thoroughly verified to prevent discrepancies later on. There
should be clarity about who is responsible for unloading. Proper procedures should be
followed to prevent mishaps, breakages, etc.
After unloading, a preliminary inspection is done comprising of the following:
z Segregation and counting of packages
z Identification of packages with respect to the shipping documents
z In case of any excess/shortage, the matter should be immediately brought to the
notice of the supplier/purchase dept/customs/transporter, as the case maybe.
z Unpacking of the packages if necessary to check the physical condition, visually.
10.2 Controlling Movement of Material

Following activities are undertaken for controlling the movement of material:
z Collection of samples
z Testing of samples in house/externally
z Inspection of materials
z Reporting and handling discrepancies
Materials procured by an organisation are often checked to ensure that they are as
per the specifications ordered. This is called inspection. In some cases, inspection is
carried out at the suppliers’ premises (it is called pre-dispatch inspection) and in others,
inspection is done after receipt at buyers’ premises (it is called post-receipt inspection).
In some cases, especially in procurement of machinery, motors, etc. the buyer inspects
the goods at different stages of production. This is called ‘stage inspection’. Generally,
inspection is a part of stores activity although in some engineering firms, inspection may
be a separate department.
Drawing of samples and custody of the samples drawn is also the responsibility of
inspection department. In case of any discrepancy between the material ordered and
material received, the Discrepancy Report is to be prepared by the inspection
department.
With more and more firms getting ISO certified, it is expected that their goods will
not need inspection, since ISO gives the assurance of uniform quality. So, while dealing
with such firms, inspection is limited to preliminary visual checking and the supplier
takes the responsibility for conformance to specifications.
10.2.1 Custody

z Raising Goods Receipt Note
z Issue of materials against requisition
Notes
z Materials movement control
z Stock taking and stock verification
After the material is received, inspected and found acceptable, a Goods Receipt
Note is issued which enables the stock to be taken into inventory and ready for receipt.
This note also helps the supplier to receive payment and is the basis for cost data in the
company.
Issue of materials is one of the core activities of a warehouse and has a direct
bearing on the production of the company. Issues are usually done against proper
requisitions, but certain uncommon situations also arise, where issues are done on
emergency basis or to repay loans taken. Issues should be done with proper
documentation to enable cost computation, cost control and management reporting.
Stock taking or Stock verification means manual counting of stores items and
comparing the physical balance with the quantity in the record books. This is necessary
to ensure that materials procured are accounted for correctly. A discrepancy would
mean either that some material has been procured but not available in stock or is
stolen, or that some material is available that has no record in the account books. Both
situations are dangerous to an organisation. A schedule is usually prepared so that all
the items in inventory are checked at least once a year.
Stock verification is a very important activity of the stores. Teams are formed and
procedures are laid out for stock taking of different kinds of items such as bulk raw
materials, fluids, etc.
One of the best examples can be seen at Wal Mart, which is precision personified,
on a gargantuan scale. Here, for stock verification, preparation alone takes four to six
weeks. 45 days in advance, the chain’s internal audit department sends a preparation
kit to each store, containing detailed instructions, including 13 schedules.
An inventory is taken between 8 a.m. to 6 p.m., while the store is open to
customers. Immediately after the inventory counting is completed, the physical count
team reconciles its findings with the book inventory. The results are reviewed later by
the internal audit department. Inventories are taken every 11 to 13 months and most
occur from March to September. Wal Mart has 60,000 to 90,000 items in its
merchandise and its inventory turnover is 4.5 times a year. It is needless to say that
ALL the items undergo physical counting every year!
Now, the question everybody must ask is how much error is acceptable? 1%, 3%,
or none at all? Every production system must have some agreement to write off
variations between what is in inventory and what records say is in inventory. The
accuracy level often recommended by experts is 0.5% for A class items, 1% for B class
items and 5% for C class items. Regardless of the specific norms decided on, the
important point is that the level should be dependable, so that safety stocks may be
provided as a cushion.
There can be many reasons why records and actuals may not agree. The legitimate
removal may have been done in a hurry and simply not recorded. Sometimes, parts are
misplaced and reappear months later. Parts are often stored in several locations, but
records may be lost or the location recorded incorrectly. There can be many more
reasons why there is a deviation!
10.3 Activities in Warehouse

Let us begin the study of Stores Management by looking at all the activities in a Stores
or Warehouse.

The activities of a warehouse have been clubbed under several headings as explained
below:
Notes
1. Stores layout and administration
2. Material receipts
3. Materials inspection
4. Custody/warehousing
5. Materials requisition
6. Inventory control
7. Databank
We shall look at each of them in some detail.
1. Stores layout and administration: Important activities are:
z Decision on optimum stores layout
z Decision on stores equipment such as forklifts, cranes, trolleys, etc.
z Stores housekeeping
z Safety and security of inventory as well as staff
z Control internal transport.
Stores should be located at convenient places near the place of operations. The
layout planning will depend on the size of operations, number and nature of items,
available space and nature of operations.
Some of the things to be kept in mind while deciding the layout are:
z Receipt section should be as close to the main entrance as possible
z Heavy and breakable items should be stored on the ground floor and lighter
materials in the upper floors
z Separate areas should be marked for rejected materials, those awaiting inspection,
radioactive materials, chemicals, steel items, costly items, etc.
z Easy movement of cranes, forklifts, etc. and easy accessibility should be of prime
importance
z Security of the stores should be an important issue.
Various types of materials are stored in a warehouse and each of these materials
may have different characteristics. Some, like iron and steel items, will rust in the
presence of humidity. Refractoriness will crumble upon excessive humidity. Rubber
items are affected by the temperature. Some materials become deformed, others have
an expiry date and some others might lose their properties upon standing. Some other
materials might evaporate when stored too long and some might get deformed. Some
very expensive materials require storage under lock and key to prevent pilferage.
Radioactive materials require permission for storage and handling. Therefore, each of
these materials requires different methods of storing. The stores layout is planned
depending on the items handled by the stores. Procedures must be laid out for handling
and storing different types of materials. Procedures formed should also include methods
of issue, indenting, stock taking, protection and security.
2. Material Receipts: Important activities are:
z Collection of material from railways and road transporters
z Receiving material from transporters
z Preparation of receipt vouchers
z Recording of incoming material.

Materials received at the warehouse could be either delivered at the door of the
company by the suppliers or his agents, or collected by the company from the Customs,
buyers' premises or the transporters' premises. In either case, before unloading, all the Notes
receipt documents are to be thoroughly verified to prevent discrepancies later on. There
should be clarity about who is responsible for unloading. Proper procedures should be
followed to prevent mishaps, breakages, etc.
After unloading, a preliminary inspection is done comprising of the following -
z Segregation and counting of packages
z Identification of packages with respect to the shipping documents
z In case of any excess/shortage, the matter should be immediately brought to the
notice of the supplier/purchase dept/customs/transporter, as the case maybe.
z Unpacking of the packages if necessary to check the physical condition, visually.
3. Materials Inspection: Important activities are:
Collection of samples
Testing of samples in house/externally
Inspection of materials
Reporting and handling discrepancies
Materials procured by an organisation are often checked to ensure that they are as
per the specifications ordered. This is called inspection. In some cases, inspection is
carried out at the suppliers' premises (it is called pre-dispatch inspection) and in others,
inspection is done after receipt at buyers' premises (it is called post-receipt inspection).
In some cases, especially in procurement of machinery, motors etc., the buyer inspects
the goods at different stages of production. This is called 'stage inspection'. Generally,
inspection is a part of stores activity although in some engineering firms, inspection may
be a separate department.
Drawing of samples and custody of the samples drawn is also the responsibility of
inspection department. In case of any discrepancy between the material ordered and
material received, the Discrepancy Report is to be prepared by the inspection
department.
With more and more firms getting ISO certified, it is expected that their goods will
not need inspection, since ISO gives the assurance of uniform quality. So, while dealing
with such firms, inspection is limited to preliminary visual checking and the supplier
takes the responsibility for conformance to specifications.
4. Custody/warehousing: Important activities are:
Raising Goods Receipt Note
Issue of materials against requisition
Materials movement control
Stock taking and stock verification
After the material is received, inspected and found acceptable, a Goods Receipt
Note is issued which enables the stock to be taken into inventory and ready for receipt.
This note also helps the supplier to receive payment and is the basis for cost data in the
company.
Issue of materials is one of the core activities of a warehouse and has a direct
bearing on the production of the company. Issues are usually done against proper
requisitions, but certain uncommon situations also arise, where issues are done on
emergency basis or to repay loans taken. Issues should be done with proper
documentation to enable cost computation, cost control and management reporting.

Stock taking or Stock verification means manual counting of stores items and
comparing the physical balance with the quantity in the record books. This is necessary
Notes to ensure that materials procured are accounted for correctly. A discrepancy would
mean either that some material has been procured but not available in stock or is
stolen, or that some material is available that has no record in the account books. Both
situations are dangerous to an organisation. A schedule is usually prepared so that all
the items in inventory are checked at least once a year.
Stock verification is a very important activity of the stores. Teams are formed and
procedures are laid out for stock taking of different kinds of items such as bulk raw
materials, fluids, etc.
One of the best examples can be seen at Wal Mart, which is precision personified,
on a gargantuan scale. Here, for stock verification, preparation alone takes four to six
weeks. 45 days in advance, the chain's internal audit department sends a preparation
kit to each store, containing detailed instructions, including 13 schedules.
An inventory is taken between 8 a.m. to 6 p.m., while the store is open to
customers. Immediately after the inventory counting is completed, the physical count
team reconciles its findings with the book inventory. The results are reviewed later by
the internal audit department. Inventories are taken every 11 to 13 months and most
occur from March to September. Wal Mart has 60,000 to 90,000 items in its
merchandise and its inventory turnover is 4.5 times a year. It is needless to say that
ALL the items undergo physical counting every year!
Now, the question everybody must ask is, how much error is acceptable? 1%, 3%,
or none at all? Every production system must have some agreement to write off
variations between what is in inventory and what records say is in inventory. The
accuracy level often recommended by experts is 0.5% for A class items, 1% for B class
items and 5% for C class items. Regardless of the specific norms decided on, the
important point is that the level should be dependable, so that safety stocks may be
provided as a cushion.
There can be many reasons why records and actuals may not agree. The
legitimate removal may have been done in a hurry and simply not recorded.
Sometimes, parts are misplaced and reappear months later. Parts are often stored in
several locations, but records may be lost or the location recorded incorrectly. There
can be many more reasons why there is a deviation!
5. Material Requisition: Important activities are:
Raising requisition for stock items
Make - Buy decision
Processing/approval for all requisitions
Budget control for stock items
Replenishment plan for items
Introduction of new items in inventory
In an industrial unit, there are a very large number of items in inventory and it is not
possible to review and monitor the level of inventory of each and every item. Hence, a
review/replenishment plan is drawn up deciding the schedule for review of items of
different groups at different points of time. The decision on quantity to be purchased is
decided depending on rate of usage/consumption, condition of the machine, plan for
repair, existing stock, safety levels, production planned, lead time for procurement, etc.
The requisition is thereafter prepared and sent to the appropriate agency for approval.
The Inventory Control Division within the Stores Department has a major role to play in
raising the Material Requisition. After the quantities are finalised, necessary budgetary
sanctions, based on last procurement prices and expected market prices are given.
Thereafter the Material Requisition goes to the Purchase Department for procurement

activity. The Stores Department also maintains the actual expenditure vis-à-vis the
budget allocation.
Notes
A very crucial area where Stores Department can contribute immensely in inventory
control is when new items are purchased by the company. A knowledgeable Stores
Department can suggest an alternative or similar material that is available in the stores
and thus prevent the procurement of a new item and thus addition to the inventory.
6. Inventory Control
Decision on stock levels for all items
Classification and inventory management decisions
Policy on surplus, obsolete, non-moving and defective items
Disposal of items
Quality control
Classification of inventory into groups of materials similar to each other from the
point of view of technical considerations is essential for easy management of inventory.
Classification is the pre-requisite for codification. Each item in the inventory will be
assigned a distinct code, which helps in the description of the item in short, thus
avoiding the necessity to use long statements every time the need to describe the item
arises. The codification system can be numeric (using numbers), mnemonic (using
alphabets), consonant (using abbreviations) or alpha-numeric (combination of alphabets
with numbers). Codification helps in standardisation.
10.4 Warehouse Location and Acquisition

The site selection revolves around two major factors: Service and Cost Product
availability can be greatly enhanced by locating the warehouse near the market.
On the other hand, if this aspect is not properly handled, the transportation cost may go
up substantially.
The other factors that have a bearing on site selection are:
z Infrastructure
z Market
z Access to the warehouse
z Primary Transportation Cost
z Availability of warehousing space
z Product Characteristics
z Regulations
z Local Levies
10.4.1 Macro Approaches

(a) Market positioned: Locating the warehouse nearest to the customer with a view to
maximize customer service levels.
(b) Production positioned: Locating the warehouse closer to the sources of supply or
production facilities.
(c) Intermediately positioned: Locating the warehouse between the final customer and
the producer. This decision will depend on the service level to be given to a
customer and the costs involved
10.4.2 Micro approach

A firm may have to consider the following points:
(a) Quality & variety of transportation carriers serving the site
Notes (b) Quality & Quantity of labor available

(c) Labor rates
(d) Cost & quality of industrial land
(e) Potential for expansion
(f) Tax structure
(g) Cost of construction
(h) Cost & availability of utilities
(i) Tax Incentives
(j) Nature of the local community
10.5 Warehouse Design and Layout

A warehouse layout basically takes care of aspects such as where should
products/materials are located in the warehouse. A good warehouse layout can:
z Increase output
z Improve Product flow
z Reduce costs
z Improve service customers
z Provide better employee working conditions
The optimal layout & design will vary with the
z Type product being stored
z The company’s financial resources
z Competitive environment
z Needs of customers
z Cost trade-offs between labor, equipment, space and information
10.6 Material Handling and Equipment

Material handling is the function of moving the right material to the right place in the
right time, in the right amount, in sequence, and in the right condition to minimize
production cost. The cost of MH estimates 20–25 of total manufacturing labor cost in
the United States.
10.6.1 Goals of Material Handling

The primary goal is to reduce unit costs of production. The other goals are:
z To maintain or improve product quality, reduce damage of materials
z To promote safety and improve working conditions
z To promote productivity
Material should flow in a straight line
Use gravity! It is free power
Move more material at one time
Mechanize material handling
Automate material handling
z Promote increased use of facilities

z Reduce tare weight (dead weight)
z Control inventory
Notes
Manufacturing processes and unit loads in many industries especially those like
Textiles, Bulk Chemicals, etc. are complex and at the same time, perhaps unique.
Properly chosen Materials Handling Equipment can be utilized for simplified order
picking within storage/retrieval system designed and developed to handle goods. For
example, Rolled Goods in a Textile Industry.
Materials handling covers virtually all aspects of all movements of raw materials,
work-in-process or finished goods within a factory or warehouse. Basically, material
movement is considered as a non-value adding activity. Hence, primary objective of a
SC Manager should be to eliminate material handling where possible. This includes
minimizing inventory, travel distance, bottlenecks and loss due to spillage, waste, wrong
handling, damage, etc. Manual sorting of materials is quite labor-intensive. It involves
separating & regrouping picked items into customer orders. Items have to be physically
examined and placed onto pallets or containers for the purpose of dispatching to
customers. This is not only time-consuming but also error-prone.
Hence, with a view to minimize manual sorting, organizations use powered or non-
powered equipments like pallets, palletizers, strapping machines, stretch wrappers etc.
Very often these equipments represent a major capital outlay for an organization. In
spite of all the developments, manual equipment has been the mainstay of the
traditional warehouse. Such equipments can be categorized according to functions
performed – storage & order picking, transportation & sorting and shipping. Similarly,
the Storage Systems can be “Fixed” or can be “Movable”, depending on the
requirements.
10.6.2 Overview of Material Handling Equipment

Material handling equipment includes:
z Transport Equipment: industrial trucks, Automated Guided vehicles (AGVs),
monorails, conveyors, cranes and hoists.
z Storage Systems: bulk storage, rack systems, shelving and bins, drawer storage,
automated storage systems.
z Unitizing Equipment: palletizers.
z Identification and Tracking systems
10.6.3 Principles of Material Handling

The main principles of material handling are as follows:
z The planning principle: Large-scale material handling projects usually require a
team approach. Material handling planning considers every move, every storage
need, and any delay in order to minimize production costs. The plan should reflect
the strategic objectives of the organization as well as the more immediate needs.
z The systems principle: MH and storage activities should be fully integrated to form a
coordinated, operational system that spans receiving, inspection, storage,
production, assembly, shipping, and the handling of returns. Information flow and
physical material flow should be integrated and treated as concurrent activities.
Methods should be provided for easily identifying materials and products, for
determining their location and status within facilities and within the supply chain.
z Simplification principle: Simplify handling by reducing, eliminating, or combining
unnecessary movement and/or equipment. Four questions to ask to simplify any
job:
Can this job be eliminated?
If we can’t eliminate, can we combine movements to reduce cost? (unit load
concept)

If we can’t eliminate or combine, can we rearrange the operations to reduce the

travel distance?
Notes If we can’t do any of the above, can we simplify?
z Gravity principle: Utilize gravity to move material whenever practical.
z Space utilization principle: The better we use our building cube, the less space we
need to buy or rent. Racks, mezzanines, and overhead conveyors are a few
examples that promote this goal.
z Unit load principle: Unit loads should be appropriately sized and configured at each
stage of the supply chain. The most common unit load is the pallet. The different
types of pallet are:
Cardboard pallets
Plastic pallets
Wooden pallets
Steel skids
z Automation principle: Materials handling operations should be mechanized and/or
automated where feasible to improve operational efficiency, increase
responsiveness, improve consistency and predictability and decrease operating
costs. ASRS is a perfect example here.
z Equipment selection principle: Questions that need to be answered are:
Why? What? Where? When? How? Who?
If we answer these questions about each move, the solution will become
evident.
z The standardization principle: One should standardize handling methods as well as
types and sizes of handling equipment. Too many sizes and brands of equipment
result in higher operational cost. A fewer sizes of carton will simplify the storage.
z The dead weight principle: Try to reduce the ratio of equipment weight to product
weight. Don’t buy equipment that is bigger than necessary. Reduce tare weight and
save money.
z The maintenance principle: Plan for preventive maintenance and scheduled repairs
of all handling equipment. Pallets and storage facilities need repair too.
z The capacity principle: Use handling equipment to help achieve desired production
capacity, i.e. material handling equipment can help to maximize production
equipment utilization.
10.6.4 Equipment & Systems

Handling Systems can be classified as follows:
1. Manual
2. Mechanized
3. Semiautomatic
4. Automatic
5. Information Guided
z Manual System: This is the cheapest and the most common method used for
material movement. However, the limitations are: Low volumes, slow speed,
physical characteristics of the product and distances.
z Mechanized System: Since mechanized equipment requires space for free
movement, the layout of the warehouse becomes a prime consideration while
deciding to go for mechanized system. The equipment should have accessibility to
the storage area for loading/unloading of material during storage and retrieval.
Mechanization’s main benefit is that it enhances system productivity. The criteria
for choosing a machine for material movement should be:
Improvement of space utilization
Reduction of time taken for material movement
Notes
Speeding up the overall material flow
Reduction in material damages during material handling
Ensuring safety of operating labor
The equipments most commonly used are:
Wheeled Trolley
Forklift
Pallet Truck
Tractor-trailer device
Conveyors
Cranes
Carousels
‘Storage & Order Picking’ Equipment
Examples: Racks, Shelves, Drawers and Operator controlled devices such as
forklifts.
z Gravity Flow Storage Racks: These are often used for storing high-demand
materials. These are well suited for Products that are of uniform size & shape.
While storing, items are loaded into the racks from the back, flow to the front of the
racks that are sloped forward. Picking is done from the front.
z Bin Shelving Systems: These are useful for small parts. Here, materials are
handpicked and as therefore, the height of the Storage System must be within the
reach of the Store/Warehouse employees. This system is relatively less costly when
compared with other storage systems. Typically, full space inside the bin cannot be
used & hence some wastage exists.
z Modular Storage Drawers & Cabinets: These are used for small parts and these are
similar to bin shelving systems. These require less space. Here, the drawers are
pulled out & materials are selected. Nuts, bolts, rivets, fasteners and other small
components are often stored in these. These are often less than 5 feet in height so
as to allow employees to easily pick items.
z Automated Materials Handling Systems: Automated Storage & Retrieval Systems
(AS/RS), Carousels, Case-picking Equipments, Robots, Conveyors and Scanners
have become part and parcel of a Warehouse. As a result, many of the World Class
Companies have succeeded in achieving substantial improvements in material
handling efficiency and productivity.
z Automated Storage & Retrieval Systems (AS/RS): The benefits include reduced
labor cost, reduced floor space, increased inventory accuracy, improved service
levels, increased control through more & better information. The disadvantages are
initial capital cost, software related issues, capacity problems, maintenance costs,
user interface & training, worker acceptance and Obsolescence. The other
equipments are:
Carousels: This is a form of AS/RS equipment and is a mechanical device that
houses & rotates items for order picking.
Conveyors: Sorting equipment can be specialized, such as tilt-tray sorter with
built-in diverting mechanisms or it can be assembled from other components
such as Conveyors.
z Automatic Guided Vehicle (AGV) Systems: AGVs are battery powered driverless
vehicles that are controlled by computers for task assignment, path selection and
positioning. AGVs are often used in automated warehouses involving AS/RSs.

z Robots: Robots are another type of equipment used in many phases of materials
handling. It is likely that materials handling robots will have a steady growth in many
Notes application areas. Robots may be used for picking, transferring or for issuing of
items.
z Computerized Documentation: Another aspect of shipping automation is
documentation. Along with other areas of the warehouse that are getting
automated, there is a need to computerize the tracking, tracing and information
systems. The Barcodes on the Items entering the warehouse are scanned and are
assigned storage locations by the computer itself.
10.7 Record Keeping

z Raising requisition for stock items
z Make–Buy decision
z Processing/approval for all requisitions
z Budget control for stock items
z Replenishment plan for items
z Introduction of new items in inventory
In an industrial unit, there are a very large number of items in inventory and it is not
possible to review and monitor the level of inventory of each and every item. Hence, a
review/replenishment plan is drawn up deciding the schedule for review of items of
different groups at different points of time. The decision on quantity to be purchased is
decided depending on rate of usage/consumption, condition of the machine, plan for
repair, existing stock, safety levels, production planned, lead time for procurement, etc.
The requisition is thereafter prepared and sent to the appropriate agency for approval.
The Inventory Control Division within the Stores Department has a major role to play in
raising the material requisition. After the quantities are finalised, necessary budgetary
sanctions, based on last procurement prices and expected market prices are given.
Thereafter the Material Requisition goes to the Purchase Department for procurement
activity. The Stores Department also maintains the actual expenditure vis-à-vis the
budget allocation.
control is when new items are purchased by the company. A knowledgeable Stores
Department can suggest an alternative or similar material that is available in the stores
and thus prevent the procurement of a new item and thus addition to the inventory
10.8 Communications
Communications in warehousing is about transforming the data which an organization
possesses and turning it into information of strategic significance. Data warehousing
explores the most pressing issue in business today — the means to improve strategic
decision making. Data warehousing represents a map for a new way of looking at data
and information. Data exists in abundance but it is often unusable to support decision
making because it is unstructured, unintegrated, aged or polluted.
z Explores the issue whether to build a full enterprise data warehouse, or whether to
go for a scaled down “data mart”
z Updated to include the latest developments, acronyms, and techniques
z Compares and contrasts relational and multidimensional databases
z Evaluates the use of data warehousing to support operational processing
z Reports on innovative designs for optimal performance of relational databases for a
“query intensive” world
z Analyzes artificial intelligence data mining tools

z Examines new case histories and the reactions of the organizations involved
It has been a momentous change. Information technology is no longer a business Notes
resource, it is the business environment. The Economist 1994 successfully combines
theory with hard-headed practical advice for those who want to proceed with a data
warehouse project. The more practical and affordable solution for many new and
existing warehouses is to empower operators by installing an onboard computer on
each forklift, making the location of items and empty storage space immediately visible.
Efforts to improve efficiency over the past century have often focused on the reduction
of waste, better communication methods.
10.9 Quality Standards

Inventory Control: Important activities are:
z Decision on stock levels for all items
z Classification and inventory management decisions
z Policy on surplus, obsolete, non-moving and defective items
z Disposal of items
z Quality control
Classification of inventory into groups of materials similar to each other from the
point of view of technical considerations is essential for easy management of inventory.
Classification is the pre-requisite for codification. Each item in the inventory will be
assigned a distinct code, which helps in the description of the item in short, thus
avoiding the necessity to use long statements every time the need to describe the item
arises. The codification system can be numeric (using numbers), mnemonic (using
alphabets), consonant (using abbreviations) or alpha-numeric (combination of alphabets
with numbers). Codification helps in Standardisation.
10.10 Summary
In today's competitive manufacturing and business environment, the vital role of
warehousing has to be properly understood. Materials received at the warehouse could
be either delivered at the door of the company by the suppliers or his agents, or
collected by the company from the customs, buyers’ premises or the transporters’
premises.
Materials procured by an organisation are often checked to ensure that they are as per
the specifications ordered. This is called inspection. Issue of materials is one of the core
activities of a warehouse and has a direct bearing on the production of the company.
Issues are usually done against proper requisitions, but certain uncommon situations
also arise, where issues are done on emergency basis or to repay loans taken.
Stores should be located at convenient places near the place of operations. The layout
planning will depend on the size of operations, number and nature of items, available
space and nature of operations. Various types of materials are stored in a warehouse
and each of these materials may have different characteristics.
Issue of materials is one of the core activities of a warehouse and has a direct bearing
on the production of the company. Issues are usually done against proper requisitions,
but certain uncommon situations also arise, where issues are done on emergency basis
or to repay loans taken.
Classification of inventory into groups of materials similar to each other from the point of
view of technical considerations is essential for easy management of inventory. Material
handling is the function of moving the right material to the right place in the right time, in
the right amount, in sequence, and in the right condition to minimize production cost.
control is when new items are purchased by the company. Communications in

warehousing is about transforming the data which an organization possesses and

turning it into information of strategic significance. Classification of inventory into groups
Notes of materials similar to each other from the point of view of technical considerations is
essential for easy management of inventory.

1. The ______________ is a critical link between the manufacturing plant and the
external world.
(a) Warehouse
(b) Material
(c) Tools
(d) Equipments
2. Materials procured by an organisation are often checked to ensure that they are as
per the _____________ ordered.
(a) Principles
(b) Specifications
(c) Classification
(d) Investigation
3. Drawing of samples and custody of the samples drawn is also the responsibility of
_______________ department.
(a) Inspection
(b) Controlling
(c) Operations
(d) Financial
4. Classification is the pre-requisite for ___________.
(a) Communication
(b) Simplification
(c) Inspection
(d) Codification
5. The Stores Department also maintains the actual ______________ vis-à-vis the
budget allocation.
(a) Expenditure
(b) Income
(c) Inventory
(d) Systems
6. A warehouse ___________ basically takes care of aspects such as where should
products/materials are located in the warehouse.
(a) Inspection
(b) Layout
(c) Manager
(d) Robots
7. ____________ may be used for picking, transferring or for issuing of items.
(a) Robots
(b) Systems

(c) Trucks
(d) Carriers
Notes
8. _______________ represents a map for a new way of looking at data and
information.
(a) Warehouse Layout
(b) Codification
(c) Classification
(d) Data Warehousing
9. Unit __________ should be appropriately sized and configured at each stage of the
supply chain.
(a) Loads
(b) Sales
(c) Purchases
(d) Stores
10. Material movement is considered as a __________ adding activity
(a) Non-Value
(b) Value
(c) Formal
(d) Complicated

1. What are the main functions of a warehouse? Write in brief.
2. What is Stores Management? Write down the objectives and responsibilities of the
stores function.
3. What is stock verification?
4. What do you understand by stores accounting?
5. What are factors have a bearing on site selection?
6. Write a note on material handling and equipment.
7. Explain warehouse design and layout.
8. Explain the type of handling equipment systems.
10.13 Key Terms

z Warehouse Location: The site selection revolves around two major factors:
Service and Cost Product availability can be greatly enhanced by locating the
warehouse near the market. The site selection is dependent upon factors such as
infrastructure, market, access to the warehouse, primary transportation cost,
availability of warehousing space, product characteristics, regulations, local levies.
z Warehouse Acquisition: The purchase of warehouse is dependent on factors
such as macro approaches- positioning of market, production and intermediately
positioned whereas in micro approaches – quality and variety of transportation
carriers serving the site, quality and quantity of labour available, labour rates, cost
and quality of industrial land, potential for expansion, tax structure, cost of
construction, cost and availability of utilities, tax incentives and nature of the local
community.
z Warehouse design and Layout: A warehouse layout basically takes care of
aspects such as where should products/materials are located in the warehouse.
The optimal layout and design will vary with the type of product being stores, the

company's financial resources, competitive environment, needs of customers, cost

trade-offs between labour, equipment, space and information.
Notes z Make- Buy Decision: The make-or-buy decision is the act of making a strategic
choice between producing an item internally (in-house) or buying it externally (from
an outside supplier).
z Communication: Communication is the act of transferring information through
verbal messages, the written word, or more subtle, non-verbal signals.

1. (a) Warehouse
2. (b) Specification
3. (a) Inspection
4. (d) Codification
5. (a) Expenditure
6. (b) Layout
7. (a) Robots
8. (d) Data Warehouse
9. (a) Loads
10. (a) Non-Value

New Delhi

Accounting for Inventories 147
Unit 11: Accounting for Inventories

Notes
Structure
11.1 Introduction
11.2 Accounting for Raw Materials
11.2.1 Base Stock Method
11.2.2 Highest in First out (HIFO)
11.3 Work-in-Progress and Finished Goods Stock
11.3.1 Importance of the FIFO in Valuation
11.3.2 Last in First Out
11.4 Stock Valuation Methods
11.4.1 Method of Average
11.5 Accounting for Loss and Pilferage
11.5.1 Normal Loss in Consignment
11.5.2 Abnormal Loss in Consignment
11.5.3 Pilferage
11.6 Summary
11.9 Key Terms
Objectives
z Understand First in First Out (FIFO) and Last in First Out
z Use method of Average
z Know the Weighted Average Method
z Define Base Stock Method
z Explain Highest in First Out (HIFO)
11.1 Introduction
An important aspect of every business is inventory management. Companies always
require the right amount of inventory items at all times for the sake of profit
maximisation. Counting inventory determines both inventory shortages and the amount
of inventory in hand at any time. From accounting purpose, a business needs to
establish the cost basis of the inventory.
A more conservative inventory valuation method is cost accounting which values
inventory based on its cost. In accounting for raw materials, inventory is valued on the
basis of items' retail price.

11.2 Accounting for Raw Materials

Notes The various methods used for accounting of raw materials are discussed below:
11.2.1 Base Stock Method

Under this method, the minimum or safety stock of materials is to be stored from the
initial lot of purchase by the enterprise. The ultimate purpose of maintaining the stock in
order to meet the emergency whenever arises. Once the base stock is created out of
the first lot of purchase, should be considered as a fixed volume forwarded from one
point of time to another.
It is the only method having the prime objective of issuing the materials to the tune
of current prices. This method normally carries out its operations either with FIFO or
LIFO. While applying the FIFO or LIFO method in the applications of the base stock
method it bears the advantages and disadvantages of the fundamental procedures of
earlier two methods. The basic objective of the method could be met out only with the
conjunction of LIFO method.
Example 1
The stock of material Z as on June 1984 is 500 units at ` 2 per unit. The following
purchases and issues of this item were made subsequently:
Date Receipts Qty.Units Rate per unit ` Issue Qty Units
Jan 6 200
Jan 10 400 2.20

Jan 15 300 2.40
Jan 20 500
Jan 21 200
Jan 24 500 2.60
Jan 25 300
Jan 28 200
Prepare a store ledger account showing how the value of the above issues should be
arrived at under the base stock method when it operates in conjunction with LIFO. Base
stock is 200 units.
Stores Ledger Base Stock Method (Last in First out Model)

Balance
Tota Tota Tota
Date Particulars Unit Unit Unit
l l l
Qty. cost Qty. cost Qty. cost
cost `
cost `
cost `
` ` `
Opening --------------------- ------------------------- 500 2 1,000
balance
Requisition
Jan 6 ------------------------ 200 2 400 300 2 600
Slip No
Jan 300 2 600
Receipt No 400 2.20 880 ---------------------
10 400 2.20 880
300 2 600
Jan
Receipt No 300 2.40 720 ---------------------- 400 2.20 880
15
300 2.40 720
Jan Requisition 300 2.40 720 300 2 600
---------------------
20 slip No 200 2.20 440 200 2.20 440

Jan Requisition
----------------------- 200 2.20 440 300 2 600
21 slip No
Notes
Jan 1,30 300 2 600
Receipt No 500 2.60 ---------------------
24 0 500 2.60 1,300
Jan Requisition 300 2 600
----------------------- 300 2.60 780
25 No 200 2.60 520
Closing Stock
Value
11.2.2 Highest in First out (HIFO)

The major underlying assumption of this method is to value the closing stock as
minimum as possible at the end of concluding the stores register. The high priced
materials are issued one after another, among the various consignments of the
materials available in the stores. This method may not only assist the firm to devalue
the stock, but also to price the issue exorbitantly. It leads to a charge through cost plus
contracts. It may be possible for the firm during the monopoly situations to increase the
price of materials.
Example 2
The stock of material M/s Murugan & Co. as on June 1984 is 1000 units at ` 2 per unit.
The following purchases and issues of this item were made subsequently:
Date Receipts Qty. Units Rate per unit ` Issue Qty Units
Stores Ledger (Highest In First Out)

Receipts Issues Balance
Date Particulars Total Unit Total Unit Total Unit
Qty. cost cost Qty. cost cost Qty. cost cost
` ` ` ` ` `
Jan 1 Opening --------------------- ------------------------- 1000 2 2,000
balance
Jan 6 Requisition ------------------------ 400 2 800 600 2 1,200
Slip No
Jan 10 Receipt No 800 2.20 1,760 --------------------- 600 2 1,200
800 2.20 1,760
Jan 15 Receipt No 600 2.40 1,440 ---------------------- 600 2.40 1,440
800 2.20 1,760
600 2 1,200
Jan 20 Requisition --------------------- 1000 600 2.40 1,440 400 2.20 880
slip No 400 2.20 880 600 2 1,200
Jan 21 Requisition ----------------------- 400 2.20 880 600 2 1,200
slip No
Jan 24 Receipt No 1000 2.60 2,600 --------------------- 1000 2.60 2,600
600 2 1,200
Jan 25 Requisition -------------------------- 600 2.60 1,560 400 2.60 1,040
No -- 600 2 1,200
Closing Stock Value

The closing stock is priced at ` 2 per Kg which leads to a minimum value of ` 1,200.
Notes 11.3 Work-in-Progress and Finished Goods Stock

The material which is first issued from the earliest consignment on hand and priced at
he cost at which that consignment was placed in stores. The materials which are
received at first to be issued first. This is the method suitable for the trend of falling
prices in the market.
11.3.1 Importance of the FIFO in Valuation

Why it is considered as a suitable method for falling prices?
The issues of the materials are made at higher prices against the low price of
replacement of materials. The low price of replacement of materials against the issues
is possible only during the trend of falling prices.
Advantages
z It is very simple to understand.
z It is issued on the basis of purchases.
z The materials are issued at purchase price.
z It is most advantageous during the moment of falling prices due to lower cost of
replacement through purchases against the issues.
z The closing stock reflects the market price due to recent purchase of materials.
Disadvantages
z There may be the possibility of clerical errors at the moment of maintaining the
stock register due to price fluctuations.
z The comparison between the jobs cannot be made possible due to various prices
involved. The materials issued for one job is at earlier prices which do not agree
with the materials issued for another job at later prices. When the price of materials
does not agree with each other, they will not be considered for comparison.
z The issue prices do not reflect the market price due to upward price trend. The main
reason is that the issues are only due to earliest consignments.
Example 3
Prepare stores ledger account on the basis of FIFO
Jan 1 Opening balance 500 units @ ` 8
Jan 5 Received from vendor 200 units @ ` 8.5
Jan 12 Received from vendor 150 units @ ` 8.20
Jan 20 Received from vendor 300 units @ ` 9
Jan 25 Received from vendor 400 units @ ` 8
Issues of materials were as follows:
Jan 14 – 200 units, Jan 10–400 units, Jan 15–100 units
Jan 19–100 units, Jan 26–200 units, Jan 30–250 units
The first step is to mention the opening balance of materials under the balance side
of the stores ledger account.
The most important step is to issue the materials from the available source of
materials in the hands of the firm. If the available source of materials is available in
terms of various price categories, the issues are to be made from the earliest
consignments till the requirement of issue is to be met. If the issue is not met within the

single price band, the next price bands are to be considered for the fulfillment of the
requirements of the issue.
Notes
The remaining value of the materials at the end of the transaction is known as value
of the closing stock.
Stores Ledger Account First In First out (FIFO)
` ` ` ` ` `
300 8 2,400
Jan 5 Receipt No 200 8.50 1,700 ------------------ 300 8 2,400

200 8.50 1,700
Jan 10 Requisition -------------------- 400 300 8 2,400 100 8.50 850
Slip No 100 8.50 850
Jan 12 Receipt No 150 8.20 1,230 -------------------------- 100 8.50 850
150 8.20 1,230
Jan 15 Requisition --------------------- 100 8.50 850 150 8.20 1,230
slip No
Jan 19 Requisition ----------------------- 100 8.20 820 50 8.20 410
slip No
Jan 20 Receipt No 300 9 2,700 -------------------------- 50 8.20 410
300 9 2,700
Jan 25 Receipt No 400 8 3,200 ------------------------------ 50 8.20 410
300 9 2,700
400 8 3,200
Jan 26 Requisition ---------------------- 200 50 8.20 410 150 9 1,350
No 150 9 1,350 400 8 3,200
9 1,350 Closing stock value
300 8 2,400
11.3.2 Last in First Out

Under this method, the issues are made at the price of latest consignment. The current
cost of the jobs/work orders are denominated only in terms of the price of the latest
consignment. During the rising prices, this is considered to be a most suitable method.
This method helps the management to quote competitive prices on the basis of latest
consignments. This method was considered by all the firms in the US as a predominant
one over the others in fixing the price on the commodities competitively during the post
Second World War years.
Advantages
z It has greater applicability only when the transactions are very minimal and prices
are steady in the environment.
z The recent purchase through the latest consignment reflects the current market
prices in the cost of sales of the firm.
z The issue of materials through latest consignments are denominated in terms of
higher prices; led to illustrate lesser profits due to higher charge during the
production and lessens the income tax burden.
Disadvantages
z Greater possibility for more number of clerical errors.
z This method also helps to compare the jobs or works.
z There may be a possibility of either overstating or understating the value of the
stock in the balance sheet.
Example 4
(The early illustration 1’s information has been considered for LIFO.)
z The first step is to highlight the opening balance under the balance column of the
store ledger of LIFO method.

z The next step is to enter the receipts if any receipts are made initially.
z The next most important step is to issue the materials out of latest consignments at
Notes first. If the latest consignments do not carry sufficient volume to issue, the next later
receipt should be taken into consideration in addition to the latest consignments.
z Finally, whatever the closing balance available at the end of all transactions is
known as the value of the closing stock of the materials.
Stores Ledger Account Last in First Out (LIFO)

` ` ` ` ` `
Closing stock value

300 9 2,250
250
8 400
50
TOTAL 2,650
11.4 STOCK VALUATION METHODS

The different stock valuation methods are discussed below:
11.4.1 Method of Average

In practice, the issue of materials cannot be made from any singular lot purchases.
Normally speaking, the materials are grouped together in categories on the basis of
similar characteristics but not on the basis of purchase price. If the materials are
grouped together irrespective of purchase price, the issues should be done
appropriately on the basis of average cost method.
The average cost method is bifurcated as follows:
z Simple average method
z Weighted average method
Simple Average Method

Under the simple average method, the issues are made only on the basis of simple
average price.
Simple Average Price
“A price which is calculated by dividing the total of the prices of materials in the stock Notes
from which the material to be priced could be drawn by the number of prices used in
that total.” I.C.M.A.
The following example will help to understand:
Illustration 5
A pillow manufacturer purchases raw cotton from three different quantities at three
different prices.
` per
Kg Kg
10,000 20
20,000 30
30,000 40
As a manufacturer of pillows, he should find out the cost of the raw cotton material at
the moment of issuance to the production centre. The issue price should be computed
as follows:
P1 + P2 + P3 ................... + Pn
Simple Average Price =
N
P1= Price of the material purchased at the first
instance, P2, P3 and so on.
N = Number of prices involved
20 + 30 + 40
Simple average price = = 30/-
3
The following transactions took place in respect of a material:
Date Receipt of Qty Rate ` Issue of Qty
29-3-2005 200
Stores Ledger Account in Simple Average Method

Date Particulars Total Unit Total Unit Unit
Qty. cost cost Qty cost cost Qty. cost
` ` ` ` `
3-3-2005 Receipts 200 4.00 800 ------------------------- 200 800
10-3-2005 Receipts 300 4.80 1,440 500 2,240
15-3-2005 Issue ---------------- 250 4.40* 1,100 250 1,140
22-3-2005 Receipt 250 5.20 1,300 ---------------------------- 500 2,440
29-3-2005 Issue 200 5** 1,000
300 1,440

The next method is weighted average method to issue the materials from the
stores. Why is the weighted average method considered to be a superior method over
Notes the simple average method?
This simple average method does not facilitate the recovery of the cost price of the
materials through the issue price of the material calculated.
From the above cited example, first the cost of the materials is to be computed.
Cost of the materials = (10,000 Kg × ` 20 +20,000 Kg × ` 30 + 30,000 Kg ×
` 40)
= ` 2,00,000+ ` 6,00,000 + ` 12,00,000
= ` 20,00,000
Recovery through issue under simple average method
= 60,000 Kg × ` 30 per Kg
= ` 18,00,000
If the issue is made through the simple average method, the cost of materials
cannot be recovered i.e. under recovery
= Cost of the materials – issue price of the material
= ` 20,00,000 – ` 18,00,000 = ` 2,00,000 (Under recovery)
It means that the total issue price is less than that of the cost of the materials by
` 2,00,000.
In order to overcome the above bottleneck which is associated, the method of
weighted average is introduced to replace the early method.
Weighted Average Method

Under the weighted average method, the issue price is found out through the
appropriate assignment of weights considered for the determination of weighted
average price.
Weighted Average Price
Weighted average price which is calculated by dividing the total cost of materials in
the stock from which the materials to be priced could be drawn by the total quantity of
materials in that stock.
Q1P1 + Q 2 P2 + Q3 P3 ............ + Q n Pn
Weighted average price = =
Q1 + Q 2 + Q3 ......Q n
Q = Quantity of materials
P = Price of the materials
Q = Assigned as weights, i.e. volume of the quantities
are used weights
The above illustration is taken for the computation weighted average price
(10, 000 Kg × ` 20 + 20, 000 Kg × ` 30 + 30, 000 Kg × ` 40)
=
10, 000 + 20, 000 + 30, 000
= ` 33.33 per Kg

Illustration 6
Stores Ledger Account in Weighted Average Method Notes

Particul Total Unit Total Unit Unit
Date
ars Qty. cost cost Qty. cost cost Qty. cost
` ` ` ` `
3-3-2005 Receipts 200 4.00 800 ------------------------- 200 800
10-3-2005 Receipts 300 4.80 1,440 500 2,240
15-3-2005 Issue ---------------- 250 4.48* 1,120 250 1,120
22-3-2005 Receipt 250 5.20 1,300 ---------------------------- 500 2,420
29-3-2005 Issue 200 4.84 968 Closing Stock

Value
300 1,452
* ⎛ 800 + 1,140 ⎞ ** ⎛ 1120 + 1,300 ⎞

⎜ ⎟ = ` 4.48 ⎜ ⎟ = ` 4.84
⎝ 200 + 300 ⎠ ⎝ 250 + 250 ⎠
How it is considered as a superior method over the early one?

The cost of the materials amounts to ` 20,00,000. The total issue price of the
materials is as follows:
= 60,000 Kg × ` 33.3333 per Kg = ` 19,99,998 approximately equals to
the cost of the materials i.e. ` 20,00,000/-
Advantages
z This method is a most rational method in finding out the issue price of the materials.
z It never takes into consideration the price fluctuations either during the trend of
rising or falling.
z Issue prices mainly depend upon the number of purchases.
z Under this method, the issue price is able to recover the cost of the materials.
z The issue price reflects or resembles the market price.
Disadvantages
z Due to different volumes of materials, clerical errors may arise.
z It lost its expression in terms of actual price of materials due to average price.
11.5 Accounting for Loss and Pilferage

Sometimes, part of goods being consigned may be lost/destroyed or damaged either in
transit or in the consignee’s warehouse. Such loss can be either normal loss or
abnormal loss.
This section discusses what are these losses and their respective accounting
treatment in Consignment Accounting.
In process costing, we can often found the output from a process is less than the
input. Where the output from a process is less than the input, there is therefore a loss.
Basically there are two types of losses in process costing:
1. Normal loss
2. Abnormal Loss

11.5.1 Normal Loss in Consignment
Notes Normal loss is unavoidable losses arising due to the nature of the material or
the process unavoidable, inherent and to natural causes like evaporation, leakage,
drying, etc.
The reasons for such loss in output can be due to the following:
z Evaporation
z Breakage
z Scrap due to high quality needed
z Rejection on inspection
z Defective Units
z Loss inherent in large scale manufacturing
z Chemical change
z Residue Material
Examples of normal losses are metal turnings, off-cuts, metal borings, edges, shred
age and ends
The quantity of normal loss anticipated is determined from past experience and
from the material specification.
The cost of normal loss is absorbed by the completed output.
The value of scrap of normal loss units is deducted from the direct material cost.
Normal loss never receives a share of the process cost.
Accounting Treatment of Normal Loss in Consignment

Consider as part of cost of goods hence when computing the value of stock on
consignment, the cost is inflated to cover the normal loss. This is done by appropriating
the cost on the basis of actual quantity available for sale.
Value of stock on consignment:

Cost of goods consigned X Unsold Quantity: Actual quantity available for sale
1. Where the loss has NO scrap value:
The quantity of loss is credited to the process account. The good output bears
the cost of the expected/normal loss
2. Where the loss has SCRAP value:
Deduct the scrap value from the process cost;
Open a Normal Loss account and debit the quantity and value of the loss and
credit the process account with the scrap value when it is sold
3. Scrap that needs to be REWORKED in that process or in an earlier process:
Credit the process account and debit stock account with the value of
the raw material/input entering the process or with the market price of such
scrap.
4. Scrap value is small:
Credit Scrap Sales account and regard the sale as a profit.
Illustration 7
Normal Loss For Company A which manufactured drink, the production manager
usually experiences a 10% loss of direct materials in the production process. In
August ’07 the details/data are as follows:
`

Direct materials (2,000 litre) 18,000
Direct labor 17,000
Overheads 12,000
Notes
Required:
(a) Compute the number of litre lost in the process.
(b) Compute the cost per litre of drink produced.
(c) Write up the process cost account.
Solution:
(a) The number of litres lost in the process:
= Total direct materials × % loss = 2,000 × 10% = 200
(b) The cost per litre of drink is computed as follows:
= Total Cost/Total output
= ` 47,000/1,800 litres
= ` 26.11 per litre
Notes: Total Cost = (Sum of direct costs plus overheads)
Total Output = 2,000 litre × (100 – 10%) = 1,800 litres
Process cost account as follows:
Litres ` Litres `
Direct materials 2,000 18,000 Normal loss 200
Labor 17,000 Output 1,800 47,000
Overheads 12,000
2,000 47,000 2,000 47,000
11.5.2 Abnormal Loss in Consignment

What is Abnormal Loss?
z Avoidable loss as it does not arise due to the nature of goods
z Caused by theft, accident, fire, pilferage, abnormal breakages, carelessness, etc.
Accounting Treatment of Abnormal Loss in Consignment

z Computed the same way as the valuation of stock on consignment after taking into
consideration the proper expenses incurred on it.
The value of loss is treated as follows:
z Debit: Abnormal Loss
z Credit: Consignment Account
z If the stock is insured, the accounting entries of the actual insurance amount
claimed is as follows:
z Debit: Insurance Company
z Credit: Abnormal loss A/c
Any amount realized on account of damaged goods should also be credited to
abnormal loss account.
The balance in abnormal loss account is debited to Income Statement.

Upon receipts from the insurance company, cash account is debited and insurance
company being credited.
Notes
11.5.3 Pilferage
The words “pilferage” and “shoplifting,” as mentioned in other lessons, are included
within the meaning of stealing, theft, larceny, and other such terms. All of these imply
theft of any quantity or any item of materiel with a monetary value. Pilferage is theft of
any kind of materiel by persons who are authorized within the facility or area. It is the
threat best controlled by package, material and vehicle control.
(a) A casual pilferer can be almost anyone. He steals if given the chance; he takes
items for individual use. He requires no assistance and steals without prior
planning. The size of the item is very important.
(b) A systematic pilferer is a person or group of people who steal according to a
preconceived plan or method. He has a motive of some form or seeks personal
profit. He carefully plans his operation, steals for monetary value, and requires the
aid of several people. The size of the item stolen is not important.
11.6 Summary
A more conservative inventory valuation method is cost accounting which values
inventory based on its cost. The ultimate purpose of maintaining the stock in order to
meet the emergency whenever arises. Once the base stock is created out of the first lot
of purchase, should be considered as a fixed volume forwarded from one point of time
to another.
The high priced materials are issued one after the another, among the various
consignment of the materials available in the stores. The HIFO method may not only
assist the firm to devalue the stock, but also to price the issue exorbitantly.
The material which is first issued from the earliest consignment on hand and priced
at he cost at which that consignment was placed in stores. The issues of the materials
are made at higher prices against the low price of replacement of materials. The low
price of replacement of materials against the issues is possible only during the trend of
falling prices.
similar characteristics but not on the basis of purchase price. If the materials are
grouped together irrespective of purchase price, the issues should be done
appropriately on the basis of average cost method.
In practice, the issue of materials cannot be made from any singular lot purchases.
similar characteristics but not on the basis of purchase price. Under the weighted
average method, the issue price is found out through the appropriate assignment of
weights considered for the determination of weighted average price. The quantity of
normal loss anticipated is determined from past experience and from the material
specification. The cost of normal loss is absorbed by the completed output.

1. The low price of replacement of materials against the issues is possible only
during the trend of ____________ prices.
(a) High
(b) Normal
(c) Falling
(d) Abnormal
2. There may be the possibility of clerical errors at the moment of maintaining the stock
register due to price ____________.
(a) Fluctuations
Notes
(b) Rise
(c) Decline
(d) Non of the above
3. The issue prices do not reflect the market price due to __________ price trend.
(a) Upward
(b) Downward
4. The remaining value of the materials at the end of the transaction is known as value
of the ___________ stock.
(a) Work-in-progress
(b) Finished Goods
(c) Opening
(d) Closing
5. The cost of normal loss is ____________ by the completed output.
(a) Absorbed
(b) Controlled
(c) Revealed
(d) Increased
6. This simple average method does not facilitate the ___________ of the cost price
of the materials through the issue price of the material calculated.
(a) Recovery
(b) Calculation
(c) Total
(d) Normal
7. In ________________ costing, we can often found the output from a process is less
than the input.
(a) Standard
(b) Absorption
(c) Process
8. A _________________ pilferer is a person or group of people who steal according
to a preconceived plan or method.
(a) Systematic
(b) Unsystematic
9. If the issue is made through the _________________ method, the cost of
materials cannot be recovered i.e. under recovery
(a) Simple Average
(b) Weighted Average

(c) LIFO
(d) FIFO
Notes
10. Any amount realized on account of ___________________ goods should also be
credited to abnormal loss account.
(a) Finished
(b) Damaged
(c) Normal

1. What is meant by inventory valuation?
2. Explain the various methods of inventory valuation.
3. Write elaborate notes on the suitability of various inventory valuation models.
4. Highlight the role of HIFO model of stores register in the lights of market structures.
5. Illustrate the importance of FIFO model of stores register in the lights of market
structures.
6. Which method is most suitable for perishable commodities? Why? Reason out the
suitability of the model.
7. Which method is most suitable for precious metals? Why? Explain the reasons.
8. Explain Normal Loss in Consignment.
11.9 Key Terms

z First-in-first Out (FIFO): The material which is first issued from the earliest
consignment on hand and priced at the cost at which that consignment was placed
in stores. The materials which are received at first to be issued first. This method is
suitable for the trend of falling prices in the market.
z Last-in-first Out (LIFO): Under this method, the issues are made at the price of
latest consignment. The current cost of the jobs/work orders are denominated only
in terms of the price of the latest consignment. During the rising prices, this is
considered to be a most suitable method.
z Weighted Average: Under the weighted average method, the issue price is found
out through the appropriate assignment of weights considered for the determination
of weighted average price.
z Normal Loss: Normal loss is unavoidable losses arising due to the nature of the
material or the process unavoidable, inherent and to natural causes like
evaporation, leakage, drying, etc
z Pilferage: Pilferage is theft of any kind of materiel by persons who are authorized
within the facility or area.

1. (c) Falling
2. (a) Fluctuations
3. (a) Upward
4. (d) Closing
5. (a) Absorbed
6. (a) Recovery
7. (c) Process
8. (a) Systematic

9. (a) Simple Average
10. (b) Damaged
Notes
New Delhi

Unit 12: Just-In-Time

Notes
Structure
12.1 Introduction
12.2 JIT Basics
12.3 Continuous Improvement - Kaizen
12.4 JIT Systems
12.4.1 Single Card Kanban System
12.4.2 Two-Card System
12.4.3 Lead-time Reduction
12.5 One-piece Flow and Group Layouts
12.5.1 Cellular Layout
12.5.2 Dedicated Lines
12.5.3 Uniform Flow
12.6 Set-up Costs and Supplier Management
12.7 JIT Supply Chain Management
12.7.1 Implementation Issues
12.8 Summary
12.11 Key Terms
Objectives
Know the concept of JIT and Kanban
Understand how is Kanban used to operate the JIT system
Explain ‘one-piece flow' and group technology
Identify the implication of reducing set-up costs
Understand 'on-demand supply chain' and how does JIT handle this issue
12.1 Introduction
Just-in-time (JIT) is both a technique and a philosophy. According to the JIT philosophy,
no products should be made, no components ordered, until there is a downstream
requirement. This philosophy is based upon the simple idea that wherever possible,
activities should only take place in a system when there is a demand for it. Therefore,
activities are postponed to latest possible point in time to reduce costs.
The underlying ideas, thoughts, and principles of JIT are in themselves long-
standing and according to some thinkers have been built upon existing thoughts in the
western world. According to them, the parallels between the JIT approach and Ford’s
Just-In-Time 163
Model ‘T’ production system are striking. Henry Ford, explained the system, which he
called the ‘refined manufacturing system’, “. . . stock will be forthcoming when needed,
that no surplus will be allowed to pile up at any point along the process line, that both Notes
the department supply of raw materials and finished parts shall be adequate at all times
and in their right places.”
However, it is argued that Ford’s inventory of finished and completed cars was
non-existent, because the demand of the products was higher than the capacity to
produce. A phenomenon called “hand-to-mouth buying” was also introduced during the
Great Depression of the USA in the 1930s.
Though all these approaches are more alike than is generally recognised, the key
difference between the systems follows from the strictly and purposefully limited
objectives of the earlier systems. Only, in the sense of inventory reduction and an
improved rate of turnover in the inventory management, JIT has been built upon
existing thoughts in the western world. Otherwise, the environments that the other
systems faced were immeasurably different.
12.2 JIT Basics

What is Just-In-Time (JIT)? In literature, the number of definitions of JIT is
overwhelming. However, two main components of the definitions seem to appear
repeatedly, namely, a continuous search for waste reduction and to make only what is
needed just in time.
JIT is defined in the APICS dictionary as “a philosophy of manufacturing based on
planned elimination of all waste and on continuous improvement of productivity”.
Another definition of JIT is: A philosophy of scheduling wherein the entire supply
channel is synchronised to respond to the requirements of operations or customer.
JIT, as is known today, was first developed at Toyota, by Taiichi Ohno and Shigeo
Shingo. Parts were produced at each step in a process only to supply the immediate
demand of the next step. Toyota started this by using containers to carry parts to the
next step that contained enough for production requirements. As the container was
emptied, it was sent back to the previous step. This became the automatic signal to
make more parts. Therefore, each step in the process made only enough parts to fill the
container and waited for the container to be emptied.
Though by introducing the JIT system at Toyota, it practically eliminated inventories,
the company ran the risk that if one small part was not available; the entire production
line would shut down. It required a solution to this problem to make the system work
effectively. It took Toyota more than 20 years to fully implement JIT and integrate it
within the Toyota production system.
A JIT system should be regarded as a holistic vertical approach or system. The goal
of the JIT concepts, contrary to popular belief, is not to reduce inventory, although that
is an appealing side benefit. Rather, the goal is to streamline the production process
and making continual improvements in processes and products. This is achieved by
inculcating a different lifestyle and business culture whose objective is to achieve
simplicity throughout the company and the supply chain.
As a philosophy, the primary goal of JIT is the elimination of waste. JIT uses waste
elimination to increase profitability, quality and productivity. Waste is considered to be
any part of the process that takes time and resources but adds little or no value to the
product. Ohno identified the following seven types of waste as the most prominent
ones:
1. Waste from overproduction
2. Waste of waiting time
3. Transportation waste
4. Processing waste

5. Inventory waste
6. Waste of motion
Notes
7. Waste from product defect
As you will see from the list given above, waste is considered to be everything that
does not add value to the product in the system. To illustrate the logic, let us first look at
rework and scrap. These are costs and obviously, instead of adding value, they take
away value and therefore, are obvious wastes and should be eliminated.
Inventory, perhaps, is less obvious as a source of waste. But consider inventory
between work centres. While the inventory sits there, no value addition takes place,
therefore it is considered waste. The concept of reduced inventory is implemented by
getting the material to the next work centre or customer just in time for the next
production step. If this is done, then inventory between production stages is reduced.
JIT continually reduces the levels of inventory in a production process until stopped by
some event. When this happens, the event is “attacked” and the barrier to further
inventory reductions (such as a lengthy set-up) is removed. Inventory reduction
continues until another barrier is encountered. Each barrier is overcome through
continuous improvement, till the system is optimised.
Similarly, it is possible to explain the logic of other wastes. Just like inventory
waiting time does not add value, nor does additional movement of the raw materials,
and work-in-process. Material in transit adds to the value of the capital used and not to
the product. If transit material is reduced, waste is also reduced.
JIT works on the principle: Produce and deliver finished goods just in time to be
sold, sub-assemblies just in time to be assembled into finished goods, fabricated parts
just in time to go into sub-assemblies, and purchased materials just in time to be
transformed into fabricated parts. As an approach to production management, it can
yield enormous productivity increases, inventory reductions, and quality improvements
and a system pursuing the goals of zero inventories, zero transactions, and zero
disruptions. In this sense, JIT is an inventory strategy implemented to improve the
return on investment of a business by reducing in-process inventory and its associated
costs.
JIT success depends on the performance of the system as a whole. Thus, the
integration among the various functions becomes critical. Because JIT crosses many
functional lines within an organisation, support from the various functional groups is
essential if JIT is to achieve its full potential. Therefore, a JIT enterprise has a flat,
team-based structure, with a high degree of work autonomy that encourages initiative
and innovation. It breaks down organizational barriers and develops highly-trained,
motivated employees who investigate problems and find solutions as part of their job.
Unlike conventional mass production principles, JIT works on a separate set of
principles in terms of strategy, organizational structure and operational capabilities.
Instead of using economies of scale, it uses small lot sizes to gain competitive
advantage. JIT has a flat structure instead of a hierarchical structure used by mass
production organisations. It requires this to encourage problem identification, hypothesis
generation, and experimentation at all levels in the organisation. It also uses a number
of tools with the objective to integrate its suppliers and think more about its customers.
The strategy, structure and capabilities of organisations are molded in a manner that
JIT becomes a synchronised consumer-driven system. The comparison is shown in
Table 12.1.
Table 12.1: Differences between JIT and Mass Manufacturing
Areas Mass Production JIT Enterprise

Affected
Business Product-out strategy focused Customer-focused strategy

strategy on exploiting economies of scale focused on identifying and

Just-In-Time 165
of stable product designs and exploiting shifting competitive
non-unique technologies. advantage by reduction in product
lot sizes. Notes
Organisa Hierarchical structures that Flat structures that encourage
tional encourage following orders. It initiative. It encourages the flow of
structure discourages the flow of vital vital information that highlights
information that highlights defects, defects, operator errors,
operator errors, equipment equipment abnormalities, and
abnormalities, and organizational organizational deficiencies at the
deficiencies at the grassroots level. grassroots level.
Operatio Tools that assume an extreme Smart tools that assume
nal capability division of labour, the following of standardised work, strength in
orders, and no problem-solving problem identification, hypothesis
skills. generation, and experimentation.
JIT does not advocate running big machines fast to absorb labour and overhead; its
approach is focused on producing the right part in the right place at the right time (in
other words, “just in time”). It does this by providing smoother production flows by
reducing product lot sizes and making continual improvements in processes and
products.
As these activities are carried out with a strong focus on the final customer,
therefore, no products are made, no components ordered, until there is a downstream
requirement. This is called a "pull approach". In the pull approach, all goods arrive
exactly when they are needed by the customer. This contributes to higher productivity,
lower levels of inventory and improved product quality for the firm and better service
and value to the customer.
12.3 Continuous Improvement - Kaizen

In essence, JIT systems are significantly different from traditional systems and involve a
relentless pursuit of process improvement and a reduction in wastes through smaller
production lot sizes. Reduction in product lot sizes triggers a chain of events involving
improved motivation, improved quality control, lower inventories and improved margins.
The ultimate objective of JIT is to obtain competitive advantage. This is accomplished
through the concept of ‘Kaizen’.
Kaizen translated from Japanese means continuous improvement, taken from
words ‘Kai’ means continuous and ‘zen’ means improvement. It is a management
philosophy and forms the basis of the Toyota Production System (TPS) as well as Lean
Manufacturing.
The central philosophy of kaizen was probably best expressed by an earlier head of
Toyota, Toyota Sakichi (1867-1930), who said that no process could ever be declared
perfect, and that therefore there was always room for improvement. Kaizen, as Toyoda
Sakichi said, is about continually aiming for improvement, not just on the shop floor but
across the whole company.
For example, TQM as developed at Toyota is an all-embracing concept, embracing
the whole company. It reflects Toyota’s belief that every worker in every department
contributes to quality, no matter how indirectly.
Kaizen strategy is one of the most important concepts in Japanese management
and is credited with being key to Japanese competitive success. Regarded as a
conceptual “umbrella” consisting of a collection of Japanese practices, Kaizen includes
the following:
Customer Orientation
Total Quality Control

Robotics
QC Circles
Notes
Suggestion Systems
Automation
Discipline in the Workplace
Total Productive Maintenance
Kanban
Zero Defects
New Product Development
Small Group Activities
Productivity Improvement
Statistical Quality Control
Cooperative Labour/Management Relations
There are three super ordinate principles which form the bedrock of the Kaizen
philosophy. These principles are:
Process creates results: Without improving process, results do not improve, Look
to improvement of one or more of the five inputs to the process – persons,
machines, methods, materials, and environment.
Total systems are more important than each of the parts: Look for optimum vs.
sub-optimum – a paisa saved in one department has no merit if it adds a rupee of
cost in another department.
Be non-blaming and non-judgmental: Determine what is wrong, not who is
wrong. Find the cause of the problem and correct it, but do not kill the messenger.
The Japanese make a distinction between kaizen and innovation: Kaizen is gradual,
while innovation is viewed as being more radical. Radical changes to an organization’s
product line, business model or other operational area – dubbed kaikaku by the
Japanese – provides the breakthrough in performance and growth, while kaizen can
help the company to maintain its momentum, and to perfect its new products, processes
and business model. Table 12.2 shows the differences between the two.
Table 12.2: Kaizen and Innovation
Factor Kaizen Innovation

Size of improvement Small improvements Major improvements
Basis of improvement Conventional knowledge Technology or equipment
Main resource Personal involvement Money investment
People involved Many people A few champions
Orientation Improve the process Improve results
Economy Even in slow economy Mainly in good economy
Kaizen is a group activity and it employs small group for initiating improvements
usually in small increments over a longer period of time. A prerequisite to forming the
team is to state some rules or guidelines for the operation and for the behaviour of the
team.
An ideal team, consist of approximately four operators, a supervisor, a manager,
and two support personnel, this bonding takes place over traditional lines of authority.
Typically, an operator may emerge as the leader of the team, although the plant
manager may also be on the team. As the operators know the process better than
Just-In-Time 167
anyone in the room, they become the experts and direct the efforts of the supervisors,
managers, and engineers. Team dynamics are quite interesting at times. The higher-
level people on the team must be open to this type of power shift. Notes
The management encourages suggestion or kaizens from employees regarding
possible improvements in their respective work areas. The success depends on the
participation and response to the program. In different organisations, there are different
measures of the performance of the Kaizen programme. The performance measures of
the Kaizen Program of Maruti Udyog Ltd. are given below:
Number of ideas generated
Number of ideas implemented (e.g. 1400 last month = number of modifications in a
product × number of units modified)
Number of suggestions given for communalisations of components across different
models
Number of suggestions for communisation of equipments across different lines
Number of suggestions for indigenization of spare parts via vendors.
These teams work on objectives laid down by the management based on
consensus. Box 12.1 gives an example of the ‘kaizen’ programmes initiated at Maruti
Udyog Ltd.
Box 12.1: Continuous Improvement Program at Maruti Udyog Ltd.
Improvements monitored at Maruti Udyog Ltd.:
Reduction in physical movement of workers.
Reduction in power consumed (kwh).
Reduction in material movement (number of handlings per vehicle).
Reduction in component rejects.
Reduction in weight of material carrying equipment (e.g., ratio of rake weight to
total weight carried by a trolley).
Reduction in line rejects (e.g. improve first pass yield at weld shop, paint shop,
assembly shop etc.).
Reduction in direct consumables (e.g., paint).
Reduction in repainting per month.
Reduction in expenditure for removing scraps specially in the press shop.
Reduction in number of failures before any scheduled preventive maintenance.
In order to be successful, change must take place rapidly. Kaizen is the process of
implementing JIT tools in a much focused effort and a short amount of time, typically
one to five days. The employees are rewarded for giving useful suggestions. These
rewards are more of recognition, such as “Kaizen man of the month” titles and
certificates or small gifts, rather than monetary worth.
The Kaizen concept is shown schematically in Figure 12.1. Continuous
improvement within the organisation is achieved by closing the crucial loop from
problem to corrective action, by ensuring that all issues and corrective actions are
brought to a full resolution and by analysing crucial data and trends.

1. Design Flow Process

Link Operations
Notes Balance workstation capacities
Redesign layout for flow 2. Total Quality Control
7. Improve Product Design Emphasize preventive Worker responsibility
Standard product configuration maintenance Measure: SQC
Standardize and reduce number Reduce lot sizes Enforce compliance
of parts Fail-safe methods
Process design with product design Automatic inspection
6. Reduce Inventory More

Look for other areas
Concurrently Solve Problems
Stores
Transit Root cause 3. Stabilize Schedule
Carousels Solve permanently Level schedule
Conveyors Team approach Underutilize capacity
Line and specialist responsibility Establish freeze windows
Continual education
Measure Performance
Emphasize Improvement
5. Work with Vendors Track trends
4. Kanban Pull
Reduce lead times Demand pull
Frequent deliveries Backflush
Project usage requirements Reduce lot sizes
Quality expectations
Figure 12.1: The Kaizen Concept

One important aspect of Kaizen is its emphasis on process, complemented with
management acknowledgement. Kaizen is oriented toward progressing in small steps.
Given that any company is likely to find results in this approach, a manager can’t
usually go wrong by employing the techniques.
12.4 JIT Systems

Just-in-time is a movement and idea that has gained wide acceptance over the past
decade. As companies became more and more competitive and the pressures from
Japan’s continuous improvement in cultures’, other firms were forced to find innovative
ways to cut costs and compete. The notion of pushing materials in large quantities no
longer makes sense. Both the financial cost and the required resources of doing so are
counter productive in the long run. It is wiser to deliver materials only just before they
are needed and only in the quantity required.
A firm cannot implement a JIT system by itself; it must have the complete
cooperation of its entire supply chain. A large amount of information is needed for a JIT
system to operate well. It demands partnerships to be formed and nurtured, almost to
the point at which an entire supply chain operates as one firm. Examples of these kinds
of partnerships are everywhere in today’s business world.
JIT is a process-based, instead of a functionally based management system. It
clearly defines the manufacturing process and terminology, along with a clear set of
associated metrics e.g., cycle time, rework, inventory waiting to be worked on, setup
time, etc.
Kanban is a Japanese word meaning flag or signal, and is a visual aid to convey the
message that action is required. JIT processes are driven by a series of signals, or
Kanban that tell production processes when to make the next part. Kanban are usually
‘tickets’ but can be simple visual signals, such as the presence or absence of a part on
a shelf.
A kanban is a tool used to promote a pull system. It is usually a printed card that
contains specific information such as part name, description, quantity, etc. The kanban
is the mechanism that allows the pull system to operate smoothly. Formulas can be

Just-In-Time 169
used for the calculation of optimal kanban quantities. One of the formulas has been
given in this section too. However, in practice, these quantities are commonly
established by consensus, rather than empirically. Notes
The kanban inventory control system has been an integral part of JIT. It works on
the basis that each process on a production line pulls just the number and type of
components the process requires, at just the right time. This is usually a physical card,
but other devices can also be used.
The kanban signals the preceding process that more WIP inventory must be
delivered to the succeeding process. It maintains an orderly and efficient flow of
materials throughout the entire manufacturing process using the production rate to
determine what time constraints exist with respect to replenishment cycles.
A kanban is a card that is attached to a storage and transport container. It identifies
the part number and container capacity, along with other information. There are two
common types of kanban systems used; the one-card system and the two-card system.
12.4.1 Single Card Kanban System

In a single-card Kanban system, parts are produced and bought according to a daily
schedule, and deliveries to the user are controlled by a Conveyance Kanban (called a
C-Kanban). In effect, the single-card system is a push system for production coupled
with a pull system for delivery to the point of use. Figure 12.2 shows the working of the
single-card Kanban system.
Work Center
A
Storage
Material flow Work Center

B
Kanban flow
Figure 12.2: Single Card Kanban System

Single-card Kanban controls deliveries very tightly, so that the using work centre
never has more than a container or two of parts. Stock points serving the work centre
are eliminated. Single-card systems work well in companies in which it is relatively easy
to associate the required quantity and timing of component parts with the schedule of
end products. These are usually companies with a relatively small range of end
products, or products which are not subject to rapid, unexpected changes in demand
levels.
Work centre ‘A’ produces a part that is moved into the storage area in containers.
Work centre ‘B’ pulls a container from storage when it needs to do work. When ‘B’ pulls
the container, the move kanban is removed from the container and placed in the card
rack at ‘A’. The move kanban in ‘A’ indicates an authorisation for ‘A’ to produce another
container of parts. ‘A’ produces a container when it has a move kanban from ‘B’. This
process is repeated at each station.
12.4.2 Two-Card System
Notes The two-card system is the more popularly used Kanban system. It uses two kinds of
kanban cards:
Conveyance Kanban (C-kanban): It signals the need to deliver more parts to the
next work centre. It specifies the kind and quantity of product which a manufacturing
process should withdraw from a preceding process. The
C- Kanban on the left in Figure 12.3 shows that the preceding process which makes
this part is forging, and the person carrying this Kanban from the subsequent
process must go to position B-2 of the forging department to withdraw drive pinions.
Each box of drive pinions contains 20 units and the shape of the box is ‘B’. This
Kanban is the 4th of 8 issued. The item back number is an abbreviation of the item.
Production Kanban (P-kanban): It signals the need to produce more parts. It
specifies the kind and quantity of product which the preceding process must
produce. The P-Kanban on the right in Figure 12.3 shows that the machining
process SB-8 must produce the crankshaft for the car type SX50BC-150. The
crankshaft produced should be placed at store F26-18. The production-ordering
Kanban is often called an in-process Kanban or simply a production Kanban.
Each process (area, cell) on the production line has two Kanban ‘post-boxes’, one
for C-Kanbans and one for P-Kanbans. At regular intervals, a worker takes C-Kanbans
that have accumulated in his process post-box, and any empty pallets, to the location
where finished parts (components, assemblies) from the preceding process are stored.
Figure 12.3: C-Kanban and P-Kanban

Say that work centre ‘B’ is using a container of parts that are next to ‘B’. A full
container is found, the P-Kanban is removed, and the C-Kanban is placed in the
container. This authorises the worker to move the container from storage to ‘B’. The
P-Kanban is then placed in a rack next to work centre ‘A’ as an authorisation to ‘A’ to
produce another container of parts. This P-Kanban is placed in a full container of parts
and moved to storage.
When this new pallet begins to be used, its C-Kanban is put back into the post-box.
At each process on the line, P-Kanbans are periodically removed from their post-box
and used to define what parts and quantities to produce next. The operation of the two
card system is shown in Figure 12.4.

Just-In-Time 171
Notes
Work Center
A
P-kanban
Storage
C-kanban
Material Flow
Work Center
Kanban Flow
B
Figure 12.4: 2-Card Kanban System

There are three rules that must be followed in this type of process:
1. No parts made unless P-Kanban authorises production
2. Exactly one P-Kanban and one C-Kanban for each container
3. Only standard containers are used, and they are always filled with the prescribed
quantity.
The number of kanban card sets required in a particular location can be calculated as:
(expected demand during lead time + safety stock)
K=
(size of the container)
If rounding is necessary, K must be rounded up to the next highest integer.
JIT strives to maximise long-term profitability and growth. Kanbans help simplify
planning and to fine-tune production to meet changing customer demand of upto
± 10 percent. The system requires planned monthly and weekly production schedules.
Kanbans simplify day-to-day flexibility, and changes to the production schedule need
only to be given to the final assembly process and will then automatically work their way
back up the line. However, coordination of material handling is critical to the effective
operation of the pull system.
Kanban systems can be tightened by removing cards or by reducing the number of
parts on a pallet. The effect will be to speed the flow through the process and hence
reduce lead times. However, it also makes the system more vulnerable to breakdowns
and other causes of dislocation. By identifying the areas within the line that are causing
disruption, efforts can be made to improve them. Thus, the overall efficiency of the line
is raised by tackling the key points.
As Figures 12.2 and 12.4 clearly show, a kanban system is a pull system, in which
the kanban is used to pull parts to the next production stage when they are needed; a
MRP system (or any schedule-based system) is a push system, in which a detailed
production schedule for each part is used to push parts to the next production stage
when scheduled. The weakness of a push system (MRP) is that customer demand must
be forecast and production lead times must be estimated accurately. The weakness of a

pull system (kanban) is that following the Lean Manufacturing philosophy is essential,
especially concerning the elements of short setup times and small lot sizes.
Notes
Just-In-time has been discussed as a way to control flows of material through
sequential processes, with particular emphasis on the pacing by downstream processes
of the production and delivery work done by upstream processes. While this and
associated issues of inventory control are important aspects of JIT as used in practice,
this emphasis misses some of the other major attributes of JIT. These are attributes that
contribute to problem solving, and process improvement.
These operations-based attributes provide sustainable competitive advantage and
have often been associated with Toyota and its affiliates. These attributes are explained
through a real life example.
The Aisin JIT System is shown in Figure 12.5. Aisin is a first-tier, auto-parts supplier
to Toyota. It also manufactures consumer products such as mattresses, sewing
machines and computerised bathroom scales. In the figure, customer orders (item 1)
determine production mix, volume, and delivery timing for the plant. Production control
creates printed manifests establishing the production mix, volume, and sequence with
one manifest for every mattress and sends the individual manifest to the start of the
quilting line (item 2). It also sends one that corresponds to the same mattress to the
start of the framing line (item 3).
For every mattress for which a manifest-set was sent to the start of quilting and
framing, a separate signal was sent to the end of the assembly line (item 4), indicating
that next mattress was to be taken to shipping.
This signal continued through the system and established for each worker when to
produce and deliver one more unit, and thereby determined each person’s correct
production pace.
Manifest:
2
3 (What to make in what order)
1 Orders
Cover sets What to make
Quilting to ‘A’ Production and when
Assembly
Control
1 Framing (small, medium,
Production pace
(springs) or large)
(When to make)
2 4
A To ‘A’ A
3
To customers
B To ‘B’ B
4 6 Customers
5 Information
5 Cover sets Material Flow
to ‘B’
Small stores
Figure 12.5: Aisin JIT System

Stores, which separated process-stages in the plant, were located between quilting
and assembly (item 5) and framing and assembly (item 6). These stores were the only
way to transfer units between the feeder and the assembly lines. They operated on a
first-in, first-out basis. Therefore, the stores protected the unambiguous production mix
and sequence established at the start of quilting and framing. Stores also protected the
production rate across process-stages because of their capacity limitations.
As materials were depleted, individual ‘kanban’ cards were sent to the person who
ordered material, thereby automatically authorising delivery of small batches of
replacement supplies. Kanban cards were the only way of reordering certain materials
and were used every time a specific customer had to reorder material of a particular

Just-In-Time 173
type. They went to a specific supplier and established the criteria of a good response
(i.e., the card for fabric-1 was different than that for fabric-2, and indicated a
pre-agreed quantity, such as 20 meters worth of cloth). Notes
The person who received the individual kanban cards reordered materials by
sending a shipment’s worth of kanban cards to the external supplier, on an established
schedule. By extending the rate and sequence with which customer orders were filled
from within the Aisin plant to external suppliers as well, the entire system was linked to
the mass customisation effort.
The plant transitioned from mass production to mass customisation in 1986. The
impact in using JIT in spite of continued increases in volume and variety is shown in
Table 12.3. One can see the increases in productivity and simultaneous reductions in
lead-time and inventory.
Table 12.3: Aisin Mattress Production: Historical Mix, Volume and Inventory
1986 1988 1992 1996 1997
Styles 200 325 670 750 850
Units per day 160 230 360 530 550
Units per person 8 11 13 20 26
Finished goods (days) 30 2.5 1.8 1.5 1.5
Productivity Index 100 138 175 197 208
This transition was achieved despite challenge characteristic of making complex items
more generally, such as multiple process stages, imbalanced and variable process
times, product variety, and fluctuations in the mix, volume, and timing of demand. Thus,
rather than facing static trade-offs along a fixed ‘production possibilities frontier’, the
plant repeatedly improved its manufacturing process and continued to achieve much
better frontiers.
Manifests traveled with mattresses at each step. The information on each manifest
established fully the criteria of what each worker had to do to achieve a good outcome.
Linking individual, customer orders to the end of production initiated a pull that extended
upstream to external suppliers. Each batch of kanban cards also had an unambiguous
meaning. First, a batch of cards was the only way to specify the mix and volume of the
next shipment, and was sent for every order.
The example shows the JIT system at work. The plant established the production
rhythm for the entire plant by structuring information unambiguously between external
customers and the plant, within the assembly line, between assembly and its feeder
process stages, and between the feeder processes and their external suppliers.
New stock is ordered when stock drops to the re-order level. This saves warehouse
space and costs. However, one drawback of the JIT system is that the re-order level is
determined by historical demand. If demand rises above the historical average demand,
the firm will deplete inventory faster than usual and cause customer service issues.
To meet a 95% service rate, a firm must carry about 3 standard deviations of
demand in safety stock. Forecasted shifts in demand should be planned for around the
Kanban until trends can be established to reset the appropriate Kanban level. Others
have suggested that recycling Kanban faster can also help flex the system by as much
as 10-30%. In recent years, manufacturers have touted a trailing 13 week average as a
better predictor than most forecasters could provide.
12.4.3 Lead-time Reduction

Lead-time Reduction minimises the time required to take a product or service from
concept to delivery. It is applicable on the factory floor and in non-manufacturing areas

as well. Customer lead time refers to the time span between customer ordering and
customer receipt. Manufacturing lead time refers to the time span from material
Notes availability at the first processing operation to completion at the last operation.
In many manufacturing plants, less than 10 percent of the total manufacturing lead
time is spent actually manufacturing the product and less than 5 percent of total
customer lead time is spent in the production process. The cumulative cycle times of
the processes in the value stream are the theoretical limit to how much lead times can
be reduced, without investing in different equipment.
Clearly, there is ample opportunity to reduce lead times in most organisations.
Reducing lead times doesn’t involve speeding up equipment to cut the cycle times or
getting plant personnel to work faster. What it does involve is the rapid fulfillment of
customer orders and the rapid transformation of raw materials into quality products in
the shortest amount of time possible.
Table 12.4: Lead Time Data of Plastics Assembly Factory
Activity Total Days %

Processing 3 7.5
In-transit .5 1.3
Set-up/ changeover .5 1.3
In queue 30 75.0
On hold-waiting for materials 4 10.0
On hold-quality 2 5.0
Total 40 100.1
The lead time analysis for the product line at a plastics plant is shown in Table 12.4. As
can be seen, the actual production accounts for only 7.5% of the total manufacturing
lead time. As in most plants, the largest contributor to lead time is queue time – the time
product is sitting idle waiting to be processed at the next operation.
This non-productive lead time results in tying up cash without adding value and
causes unnecessary customer waiting. The approach to this problem is:
Measure current lead times and set improvement targets.
Change the organisation from a functional orientation to a product orientation.
Cross-train plant personnel within cells in a number of operations for greater
flexibility.
Empower work cells and teams to take ownership for the entire value stream.
Continually reduce batch sizes between work centres.
Institute local scheduling between work cells.
By employing these principles, many world-class manufacturers have shrunk lead
time by 50-80%, gained market share, improved profitability and increased employee
morale.
One of the most common applications of lead-time reduction is new product
development. Companies can gain strategic advantages over the competition.
Companies, that practice JIT with shorter lead times, can bring a concept to the hands
of the consumer while the competition was still developing it.
For example, partnerships, concurrent engineering, and sourcing out the new
product development process have allowed most automobile companies to shorten their

Just-In-Time 175
lead times for new models to eighteen months or less whereas earlier a sixty month
development lead-time was not uncommon for most automobile companies.
Notes
As the examples in this section have shown, when implemented correctly, JIT can
lead to dramatic improvements in a manufacturing organisation’s return on investment,
quality, and efficiency.
12.5 One-piece Flow and Group Layouts

The design of the production process and the plant layout are critical components for
ease of flow in a JIT environment. The basic theory in plant layout is that there is no
need to build inventory between processes, with one exception. A bottleneck operation
should always have more than one unit in front of it to ensure that it never stops due to
a lack of material to process.
This is applied through a system known as ‘one-piece flow’. One-piece flow is
essentially an inventory reduction effort with other benefits, such as in the areas of
quality and space reduction. Errors are also reduced simply due to the reduced amount
of WIP material in the area. Several common techniques, such as group technology
(more commonly identified as cellular layout) and dedicated lines are used in JIT to
allow uninterrupted product flow as required by the one-piece system.
12.5.1 Cellular Layout

Cellular layout is based on group technology principles. That means, it is a combination
of both process and product layout and incorporates the strong points of both of these.
Conventional layouts, product and process layouts, are two extremes of the spectrum.
This layout is suitable when a large variety of products are needed in small volumes
(or batches). The group technology principle suggests that parts, which are similar in
design or manufacturing operations, are grouped into one family, called part-family. For
each part-family, a dedicated cluster of machines (called ‘machine cells’) are identified.
Generally, all the processing requirements of a particular part-family are completed in
its corresponding machine cell, eliminating inter-cell transfers of the part.
Group technology and cellular layouts can be combined and used to produce
families of parts more economically than traditional process or product layouts. Data is
gathered to identify parts with similar characteristics, which are also manufactured
similarly. Groups of items can be formed either according to similarities in their design
(external features such as size, shape, use, etc.) or according to similarities in their
manufacturing process.
Cellular manufacturing makes it possible for people and machines to work together
as efficiently as possible. In order to reduce the distance between stations, the concept
of cellular layout is applied. One-piece flow is promoted through the close arrangement
of the succeeding operations, thus eliminating excessive material handling between
them. Communications are enhanced because of the proximity of the operators to one
another within the cell. The lack of separation, departmental boundaries, or walls boosts
communication and cooperation between operators.
With cellular manufacturing, you make one product at a time immediately – the
opposite of mass-batch method, where products are processed and set aside for
assembly. The workstations are set up next to each other in the shape of a “U”. This is
where the term “cell” originates, as each production line becomes a turnkey ‘cell’ that
processes the part or product completely from start to finish. This type of layout is
shown in Figure 12.6.

Notes
CELL # 1 CELL # 2
CELL # 3 CELL # 4
Figure 12.6: A Cellular Layout

Cellular manufacturing has been adopted by a number of companies in India. TI
Cycles is an example. The shop floor was organised along technical processes –
machining, painting and assembly. All equipment needed to make a family of parts was
housed in one hanger of the shop floor. The parts were sent to a central warehouse for
packing and dispatch. The components needed to assemble four cycles were grouped
together and packed and dispatched to the dealer. This led to non arrival of parts for
packing the completely knock down kits, increase in the inventories, and considerable
increase in waiting time (five to seven days) for the trucks outside the central
warehousing facility.
In 1994-95, the shop floor layout was restructured on the modular concept into five
modules. The first four were grouped according to bicycle models having similarities in
features, technology, colour, design, etc. The Rim module was a common support
module for the four. Besides, a Dispatch module was created to take care of dispatches
of domestic bicycles. The module was expected to take ownership responsibility for
buying out components, maintenance, stores of raw materials and intermediate
production planning, assembly in batches of 500 cycles, and dispatch to the dispatching
module.
The results were dramatic. Reorganisation led to the reduction of waiting time for
trucks. In 1995-96, the percentage of trucks waiting for more than 96 hours reduced to
23. It reduced further to 3% in 1997-98. By 1998-99, no truck waited for more than
24 hours. A consequence of streamlining, discrepancy in delivery reduced from 27% in
1994-95 to 16% in 1996-97. It reduced further to 2% in 1998-99.
Quality is enhanced through improved communications within the cell and through
one-piece flow. If a process within the cell is producing defective parts and only one is
being produced before moving to the next process within the cell, a maximum of two
defective parts will be produced before being discovered unlike a typical manufacturing
setting, where the number could be in the thousands before defection.
In addition, a cellular layout promotes multifunctional operators. Rather than
performing one continuous task hour after hour, operators are required to perform a
variety of tasks and operations. Each operator now makes decisions, within specified
guidelines, and discusses issues with the other operators in the cell. They function more
as a team than do individuals in a batch department performing the same task.
Operators perform better and are absent less often.
Few techniques offer as much as this breakthrough method of manufacturing.
Cellular Flow:
Reduces process lead times by as much as 95%
Just-In-Time 177
Reduces work-in-process by 90%
Reduces floor space you use by 50% to 75%
Notes
Along with these changes, productivity can increase by 40% or more with
cellular/flow manufacturing. However, changing from a traditional batch operation to a
cellular layout is challenging, but workers prefer it because it is more interesting.
Operators take ownership of what they are producing. It promotes flexibility and reduces
capital costs. Most importantly, operators feel less like machines and more like thinking
human beings when they practice lean manufacturing.
12.5.2 Dedicated Lines

Dedicated lines can be designed for the organisation or can be created by rearranging
layout. The principle is to allow for a minimum amount of flow time between
workstations. This will also speed the flow by allowing a transfer batch separate from
the process batch to be moved to the next process operation. If the work centres are
immediately adjacent, the transfer batch could be as little as one.
An example is Hewlett Packard who used the Kanban system by rearranging the
layout. The Kanban area was a section of the bench between each worker which was
marked with masking tape in a rectangle equal to the size of the unit being assembled.
The workers were on different stations on adjacent assembly benches. This made the
transfer of material easier. When the first worker completed his operations, the unit was
placed in the kanban area between that worker and the next. The second worker would
do the assigned operations from the unit in the first kanban area and place it in the next
kanban area. If a unit occupied a kanban space between a worker and the subsequent
worker, a worker could not start on a unit until that area was clear. This prevented
inventory buildup and forced workers to ensure that they completed the assigned
assembly operations correctly because the next worker would find any incorrect
operations.
12.5.3 Uniform Flow

Uniform level flow is a requirement for a successful JIT. The schedule must take the
demands for products and start to batch them into daily quantities so that the final
assembly schedule cycles through the products. Consider three products ‘A’, ‘B’, and
‘C’ that have production requirements per day as shown in Table 12.5. A uniform flow
will allow for uniform work centre flows and loads.
Table 12.5: Production Cycles
Product Requirement per Day Number required per Cycle
A 400 4
B 500 5
C 600 6
Total 1500 15
The daily requirements could be produced in batches equal to the per day
requirements. This would result in imbalance at the work centres if the subassemblies
needed for product ‘A’ are different from ‘B’ and ‘C’. To balance the load, the production
is normally carried out in smaller lots per cycle.
The number per cycle can be obtained by dividing the daily requirement by the
largest common denominator of 100. The cycle would then consist of 15 units, 4 A’s, 5
B’s and 6 C’s. Say,
ABCBCBABCACBCAC
This type of schedule would result in a relatively even load in supplying the sub-
assembly work centres. In order to achieve this type of flow and schedule, one-piece

flow is most applicable. This is more easily done in an environment where material
movement is automated.
Notes
There are numerous advantages in using this type of one-piece flow system. Some
of the advantages of this system are as follows:
Reduced setup times allow smaller lots
Incremental inventory is reduced to force problems into the open
Workers are cross-trained to allow higher efficiency of the workforce
A level schedule is maintained so that flow is easier to balance throughout the
process
Operations are balanced to allow even flow and to prevent inventory between work
centres.
One piece flow is also the building block of Flexible Manufacturing Systems (FMS).
It is, in essence, FMS with some manual operations. These principles are adopted in
FMS because the concepts make it easier to process large volume of information
because of the decomposed manufacturing system; it is easier to manage the
operational facilities compared to functional manufacturing due to limitation on cell size,
and the technological compulsions often require grouping some operations like forging
machines and heat treatment unit.
12.6 Set-up Costs and Supplier Management

Another way of looking at a JIT is as a manufacturing system that is focused to improve
product quality and productivity through the elimination of waste from all operations.
This is done by adopting a practice of manufacturing in small lots frequently. Small lot
sizes contribute to higher productivity in a firm through lower levels of inventory and
scrap, high product quality, lower inspection costs, increased flexibility and earlier
detection of defects, etc. This issue is applicable both to the internal processes of the
organisation as well as the supply chain.
The idea of JIT is to create a ‘pull’ system in the production processes. This has to
be justified in terms of the set-up cost, as it involves frequent set-ups. In order to reduce
set-up time, we have to examine if we can simplify the process from the point of view of
setting up and changing over. There are two types of setup times possible.
The internal setup time is the time tied to setting up the process or machine when it
is not running production.
The external setup time is the setup time that takes place when a process or
machine is running.
In JIT, the goal is to reduce the required setup time that results in machine
downtime. The premise is that in many processes, when the machinery is producing,
the operator is not 100% utilised or occupied. As a result, the operator may, depending
on the process and the machinery, perform some setup tasks during the time that the
process or machine is running.
Setup time is also directly related to production lot sizes. As setup times are
reduced, lot sizes are also reduced. To ensure that production is not disrupted,
problems must be identified and sorted out and the quality must be extremely high.
Reducing lot sizes decreases total manufacturing lead-time geometrically, particularly
when the process involves multiple operations.
Because of what has been said earlier and for other reasons too, manufacturers
see many benefits when setup reduction is implemented. Some of the benefits are
given below:
Shorter lead times
Less material waste
Fewer defects
Just-In-Time 179
Less inventory
Smaller space requirements
Notes
Higher productivity
Greater flexibility
Increased capacity
Reducing batch sizes also forces problems out into the open. Quality problems are
often the first to surface. Mistakes happen in organisations for many reasons. However,
almost all of them can be prevented, if people make the effort to identify when problems
happen, define root causes, and then take the proper corrective actions. With traditional
manufacturing, the lots are large so a few defective units cause few problems because
they may be placed aside and the next unit used. This is not true when the lot size is
small. A defective unit will cause disruption in the production process. This discovery is
actually advantageous and allows problems to be solved.
Setting marks, or poka-yokes mechanisms, determine the starting point for settings.
A poka-yoke is an error-proofing device. It is used as the key to Setup Time Reduction
projects. The technique is to revisit the setup operation periodically to audit the results
from the previous project, and to reduce the setup time again and again. This is done by
analysing the setup process, break it down into identifiable elements, and differentiate
between elements of the setup that are internal and external. Then you’ll find ways to
decrease setup times in the operation. Some operations that are done during setup can
be completed prior to setup. Other functions can be eliminated entirely. And some
functions simply need to be streamlined. Decreases in setup time of 50% or better are
common.
Machines Materials
Warehouse
Die Shelf
Figure 12.7: Layout of Plastic Assembly Factory

For example, the layout of a ten-machine department producing plastic assemblies
is given in Figure 12.7. The machines are located close to one another, the material or
dies are stored at the other end of the hall. One operator runs one machine. Each
operator/machine currently produces three large equally sized lots per day at the rate of
five units per minute. The operator has to perform one setup at the start of the shift and
two other setups for the different lots during the remainder of the shift. The initial set-up
time was 100 minutes and these activities are performed while the machine is not
running.
The departments setup a project with the objective to reduce the set-up time. As all
of the activity times were internal to the setup, the methodology used was to eliminate
or reduce all internal setup activities. Though some activities, such as ‘Remove Die’
cannot be performed while the machine is running, many internal activities may be
performed while the machine was running, either before or after the setup takes place.
The improvement team documented the project. The existing method is shown on
the left-hand side of the table. Some of the observations of the team are given below
and form an excellent illustration of the poka-yoke mechanism:

The ‘Clean around Machine’ activity can take place while the machine is running
before the setup.
Notes Paperwork for the previous lot could be delayed until after the machine has been
restarted on the next production lot.
The dies were stored on a shelf in the opposite corner of the department, by
relocating the shelf to a more central location; the distance traveled could be
reduced and also the time required for the activity.
Also, the trips to return the die from the previous lot and the trip to obtain the die for
the next lot could be split up. Obtaining the die for the next production lot will be
performed before the setup, and returning the die from the previous production lot
will be done after production.
Obtaining the die for the next lot and preheating it, could be performed while the
machine was running before the setup, so the machine will not be stopped while this
takes place.
By restructuring and redesigning the process and the workplace, the Setup Time
Reduction Project, was able to show dramatic results. The final recommendations are
shown on the right hand side of Table 12.6. The internal setup time was reduced from
100 minutes to 23 minutes. As the setup took place three times per machine per shift,
the total daily savings in machine run time was 6,930 minutes per day. Based on the
existing production rate, the department could now run 34,650 additional units per
production day.
Table 12.6: Operations of the Plastic Assembly Factory
Operation Before Changes Setup Operation After Changes Setup

Time Time
Stop Machine * Clean Area Around Machine 5 mins.
Clean Area Around Machine 5 mins. Find and obtain Tools 1 mins.
Fill Out Paperwork For 4 mins. Obtain Die for Next Lot from 2 mins.
Previous Lot Shelf
Return Material From Previous 10 mins. Pre Heat Die for Next lot 22 mins.
Lot
Find And Obtain Tools 3 mins. Obtain Die for Next Lot from 3 mins.
Staging
Remove Die For Previous Lot 7 mins. Stop Machine *
From Machine
Clean Inside Die 2 mins. Remove Die from Machine for 6 mins.
next lot
Return Die/Obtain Die For 8 mins. Clean Inside Die 2 mins.
Next Lot
Pre-Heat Die For Next Lot 22 mins. Install Die into Machine for 8 mins.
Next Lot
Install Die For Next Lot Into 9 mins. Make adjustments 1 mins.
Machine
Make Adjustments 2 mins. Feed material for next Lot 3 mins.
Locate & Obtain Material For 16 mins. Make ten test widgets 2 mins.
Next Lot

Just-In-Time 181
Feed Material For Next Lot 3 mins. Check Dimensions for ten time 1 mins.
widgets Notes
Make Thirty Test Widgets 6 mins. Start machine *
Check Dimensions on Thirty 3 mins. Stage unused material from 3 mins.
Test Widgets Previous Lot
Start Machine * Return die from previous Lot to 2 mins.
shelf
Fill out paper work for previous 4 mins.
lot
Total External Time For 0 mins. Total External Time For 42 mins.
Setup Setup
Total Internal Time For 100 Total Internal Time For Setup 23 mins.
Setup mins.
The company stopped operations on Saturdays and saved the overtime associated
with the operators, the supervisor, and the support departments. The company also was
able to ship the last orders of the week on Friday midnight instead of Monday morning.
Average inventories were reduced and customers were more satisfied with earlier
shipments.
12.7 JIT Supply Chain Management

Many of the most successful companies have developed a JIT strategy of focusing on
the areas in which they have a competitive edge, their core business. As a result, the
companies decide to purchase non-core functional needs from outside suppliers. Time
and resource constraints often make the utilisation of external suppliers a viable option.
A prime prerequisite for a successful JIT system is the effective linkage of the producer
and the supplier so as to facilitate frequent shipment of purchased parts in small lots.
For this strategy to be successful, it requires the company to develop long-term buyer-
vendor relationships. The development of such relationships is important for a
successful JIT system.
As mentioned earlier, the issue of reduced set-up times has to be pursued not only
within the organisation but also for the supply chain. At some point, it should become
obvious to the organisation that those who supply materials to the plant must participate
in the process for the firm to gain the full advantage of the JIT system. If large batches
arrive at the stores, the raw material and purchased parts inventory will still be large to
make a large impact on the inventory costs and the quality performance of the suppliers
may not be conducive to JIT operations.
The evolution of the supply chain is shown in Figure 12.8. It extends the concept
from a static to an on-demand supply chain. JIT has as its objective the creation of a
‘On-demand Supply Chain’. Alliances and partnerships represent a strategy that JIT
corporations have strongly promoted and relied on for many years.
There are many advantages to build on-demand supply chains. For example, by
developing its supply chain effectively, Maruti is able to monitor delivery schedules to
assembly lines closely and reduce inventory levels significantly. MUL has the target
inventory level of about Rs. 25 crore, or a little more than 1% of total purchases.
However, to reach that stage, some harsh issues will have to be faced and
solutions found. Successful JIT, therefore, places new demands on the purchasing
department. Small lot sizes are the hallmark of JIT, and are considered important
enough to warrant overcoming the obstacles of higher delivery costs and loss of
discount rates. Under JIT, purchasing seeks to move away from the traditional
adversarial role by establishing and managing supplier-partners.
Adopting the practice of more frequent deliveries in small lot sizes based on a long-
term, co-operative relationship between buyer and supplier must be mutually beneficial.
Notes Without this mutually-beneficial relationship, simple long-term contract commitment by
negotiation may not promote a move towards the full potential of JIT.
Open network supporting standards

with rapid reconfiguration
Variable cost structure On demand
Outsource all non-cure supply chain supply chain
activities 5.
Dashboards monitor end-to-end
performance and alert exceptions
External
collaboration
Horizontal
Integration Integrated distribution network
Functional with customers
Static supply excellence Common outsourced partners
4.
Visibility to entire order-to-
chain
cash cycle
Enterprise integrated Commitments are demand-
3. network, shared assets driven with managed
Common network and Common use of outsourced replenishment
2. logistics and contract
infrastructure
Different logistics networks
1. Some outsourcing-business manufacturing providers
infrastructure by business unit Cross-functional visibility to
unit differentiated
No enterprise approach to inventory and shipments
Different services to key
outsourcing of logistics and Differentiated services based
customers
fulfillment functions
Customer order online/EDL on customer segmentation
Focus on production and supply
receive acknowledgements
in customers in ready state
Experience high inventory levels/
frequent stock-outs
Traditional On demand
Figure 12.8: The Supply Chain Evolution

Furthermore, the input material deliveries depend on the manufacturer’s production
schedule. In this type of a JIT environment, it is important to find the optimal number of
deliveries of the finished product to the buyer and raw materials to the vendor, such that
both parties benefit. The determination of the optimal number of deliveries is normally
made based on the total relevant cost incurred by all parties rather than using the
independent cost function of any one party alone.
Let us look at the example below to understand the impact on inventory carrying
costs on the buyer and the vendor by taking decisions based on considerations of the
total relevant cost.
Example 12.1:
A supply chain has two members, one buyer and one seller. The buyer needs
10,000 units of an item per year. Buyer’s ordering cost is Rs. 450 per order. Buyer’s
holding cost is Rs. 100 per unit per year. The seller sets up a production run and
produces the buyer’s EOQ and dispatches it. His setup cost per set up is Rs. 2750. The
seller does not hold any inventory. If the two operate independently, what are the
buyer’s inventory costs and if they join together and operate as one unit, what will be
the total system cost? Why is the EOQ, in the two cases, different?
Solution:
If the two operate independently, costs are:
TVC(Q) = BuyerÊs ordering cost + BuyerÊs holding cost = DS/Q + HQ/2
And
Q = Q* = (2DS/H) = (2DS/FP) = EOQ
Where
‘Q’ – Lot size
*
Q – Economic Order quantity

Just-In-Time 183
‘S’ – Set-up cost or ordering (Rs./year)
‘D’ – Annual Demand
Notes
‘P’ – Unit Price (Rs./unit)
‘H’ – Holding or Carrying cost per Unit (Rs./Unit)
Q* = (2DS/H) = (2 × 10000 × 450/100) = 10 × 30 = 300 units
Buyer’s ordering cost = 450 × 10000/300 = Rs. 15,000
Buyer’s holding cost = 100 × 300/2 = Rs. 15,000
Total = Rs. 30,000
Seller’s setup cost = 2750 × 10000/300 = Rs. 91,667
Total cost to the system = Rs. 30,000 + Rs. 91,667 = Rs. 121,667
If they join together and operate as one unit,
Annual demand = 10000,
Ordering cost per order = Rs. 450 + 2750 = Rs. 3200,
Inventory holding cost per unit per year = Rs. 100
EOQ = (2DS/H) = (2 × 10000 × 3200/100) = 10 × 80 = 800 units
Buyer’s ordering cost = Rs. 450 × 10000/800 = Rs. 5625
Holding cost = Rs.100 × 800/2 = Rs. 40000
Total = Rs. 45,625
Seller’s setup cost = Rs. 2750 × 100000/800 = Rs. 34,375
Total system cost = Rs. 45,625 + Rs. 34,375 = Rs. 80,000
Total system cost comes down! There is a saving of nearly 50 percent for the buyer
though the buyer’s internal costs have gone up from Rs. 30,000 to Rs. 45,625. By
considering the relevant cost incurred by all parties rather than using the independent
cost function of any one party alone, the system has benefited considerably.
This concept of joint optimization for buyer and vendor has as its long-term
objective to create a true “pull” production/delivery system. In addition, the various
components of the supply chain also have to work satisfactorily and optimally. A
successful implementation of JIT increases reliance on all members of the supply chain.
However, to do so, there is a need to bring down the set-up costs. Setup time reduction
is an important aspect for successful implementation of JIT.
Consider the example of Economic Order Quantity (EOQ) discussed previously. If
the setup cost is considered a surrogate for the setup time, then a reduced setup cost
will result in smaller EOQ value. EOQ have been worked out for the combined operation
as 800 units. This would be about 24 days of inventory (considering 300 working days a
year).
In the example above, if the combined set-up cost is reduced to Rs. 2000, the EOQ
would be:
EOQ = (2DS/H) = (2 × 10000 × 2000/100) = 10 × 20 = 200 units
And for the combined operation
TVC = Rs. (100 × 200/2) + (2000 × 10000/200) = Rs. 10,000 + Rs. 20,000 = Rs. 30,000
As will be seen by reducing the set-up cost, we have been able to decrease the lot size.
Say that we want to have a lot that equals one day’s worth of demand, given 300
working days per year. To do so, first we need to find the setup cost that would
accomplish this.

We can rearrange the EOQ formula to arrive at the value of set-up cost that will make
this possible:
Notes
S = H * Q2 / 2 * D
Since Q is one days demand, it will be around 33 units. Substituting this in the formula:
S = 100 (33)2/2 × 10000 = 1110/2 = Rs. 55
The total cost would then become:
TVC = Rs. (100 × 33/2) + (55 × 10000/33) = Rs. 1650 + Rs. 16,667 = Rs. 18,317
This example illustrates the type of pay-off; the total inventory cost has decreased from
Rs. 121,667 to Rs. 80,000 by considering joint optimization and it has finally come down
to Rs. 18,317 by implement set-up time reduction in keeping with the JIT requirements.
This will require restructuring and redesigning the process and the workplace. The
methodology used to accomplish this has been discussed earlier in the example of the
plastic factory. In JIT purchasing, the responsibility of finding the optimal solution rests
both with the buyer and the vendor. This is an important aspect of the long-term, co-
operative relationship between the buyer and the supplier.
12.7.1 Implementation Issues

As with any new system, implementation must be done purposefully so that success is
assured. Just as we have discussed in the case of MRP and DRP, JIT cannot be
implemented without the active cooperation of the workforce, supervisors, and
managers. We have also mentioned earlier that it took Toyota nearly ten years to
successfully implement the system. Luckily, the Toyota experience has helped others to
significantly shorten the implementation period.
Implementation of JIT is accomplished through a continuous improvement process.
Lot sizes are reduced, problems must be located, quality must be improved, and setup
times and costs must be reduced to make the smaller lots economically feasible.
Problem identification, hypothesis generation, and experimentation are carried out at all
levels in a JIT organisation. Therefore, those who have to work with the system have to
embrace it.
In addition to workforce management being critical to the success of JIT, education
and training are required to ensure that all understand the objectives, methods and
techniques of the JIT system. Improved skills will allow workers to improve the process
and allow workers to bring forth observations and improvements in the manufacturing
process. This is a basic concept of the implementation process of JIT.
Another implementation issue is to build on-demand supply chains. To be able to do
this, two key questions that need to be addressed are:
1. How do you effectively integrate suppliers into the supply chain to convert it to a
‘on demand’ supply chain, and
2. How do you share information to achieve optimization?
The answer to these questions lies in building competencies in the eight identified
areas given below.
1. Understanding Change,
2. Peak-to-Peak Performance,
3. Customer Satisfaction,
4. Total Operations,
5. Manufacturing Synthesis,
6. Distribution Synthesis,
7. SCS Partnerships, and

Just-In-Time 185
8. SCS Communication.
Companies can build trust – but this elusive element is absolutely essential to any Notes
kind of successful alliance. Major Japanese manufacturers generally use a single
source for various material requirements. This is especially true for firms using the Just-
in-time operations strategy. This is one way of building trust.
Trust plays a central role in partnerships, what is important is to determine how to
build trust with supply chain partners, and identify the tools that practitioners can apply
in building alliances. Many companies have done so successfully. Trust can be built
even with multiple sources. For example, Infosys has strategic alliance partnerships
with leading package vendors including SAP, Oracle, Supply Challenge, Yantra, etc.
Whether you use a single source or multiple sources, the ultimate objective of the
supply chain and purchasing strategy is to build trust.
12.8 Summary
JIT has two main components, namely, a continuous search for waste reduction and to
make only what is needed just in time. JIT is defined in the APICS dictionary as “a
philosophy of manufacturing based on planned elimination of all waste and on
continuous improvement of productivity”.
A JIT system should be regarded as a holistic vertical approach or system. The goal
of the JIT concepts is to streamline the production process and making continual
improvements in processes and products. Reduction in inventory is a side benefit. JIT
uses waste elimination to increase profitability, quality and productivity. Waste is
considered to be any part of the process that takes time and resources but adds little or
no value to the product. There are seven types of waste: Overproduction, Waiting time,
Transportation waste, Processing waste, Inventory waste, Waste of motion and Waste
from product defects.
JIT has as its objective the creation of an ‘On-demand Supply Chain’. This is done
by establishing and managing supplier-partners. Lot size determination is normally
made based on the total relevant cost incurred by all parties rather than using the
independent cost function of any one party alone. Setup time reduction is an important
aspect for successful implementation of JIT in the supply chain also. This is done jointly
by teams from the vendor and the buyer. The ultimate objective of the supply chain and
purchasing strategy is to build trust and this is necessary to create an‘On-demand
Supply Chain’.
Workforce management is critical to the success of JIT implementation. Education
and training are also necessary prerequisites to ensure that all understand the
objectives, methods and techniques of the JIT system and JIT is successfully
implemented.

1. Just-in-time (JIT) is both a technique and a _____________.
(a) Philosophy
(b) Psychology
(a) Science
(b) Sociology
2. A JIT system should be regarded as a _________ vertical approach or system.
(a) Holistic
(b) Healthy
(c) Complex


3. As a philosophy, the primary goal of JIT is the ____________ of waste.
Notes
(a) Transportation
(b) Increase
(c) Control
(d) Elimination
4. Dedicated lines can be designed for the organisation or can be created by
rearranging ___________.
(a) Layout
(b) Plan
(c) Organisational structure
5. Implementation of JIT is accomplished through a _______________ improvement
process.
(a) Mismatched
(b) Temporary
(c) Continuous
(d) Permanent
6. JIT has two main components, namely, a continuous search for waste reduction
and to make only what is needed ____________.
(a) Just in time
(b) Before the time
(c) After the time
7. JIT has as its objective the creation of an ‘On-__________ Supply Chain’.
(a) Time
(b) Demand
(c) Location
8. _______________ management is critical to the success of JIT implementation.
(a) Company
(b) Financial
(c) Labour
(d) Workforce
9. The two-card system is the more popularly used ____________ system.
(a) Kanban
(b) Inventory
(c) Storage
(d) Controlling
10. The idea of JIT is to create a ‘__________’ system in the production processes.
(a) Push
(b) Pull
(c) Push and Pull

Just-In-Time 187
1. Is it possible to achieve zero inventories? Why or why not? Notes
2. Stopping waste is a vital part of JIT. Identify some sources of waste in your
classroom and discuss how they may be eliminated.
3. Discuss ways to use JIT to improve one of the following: A fast food restaurant; or a
hospital; or an auto dealership.
4. What are the roles of suppliers and customers in a JIT system?
5. Are there any companies or industries that you can think of for which JIT would be
totally inappropriate? Why?
6. A local hospital wants to set up a kanban system to mange its supply of blood with
the regional blood bank. The regional blood bank delivers blood to the hospital each
day with a one-day order lead time (an order placed by 6 P.M. today will be
delivered tomorrow afternoon). Internally, the hospital purchasing group places
orders for blood each day at 5 P.M. Blood is measured by the pint and is shipped in
containers that contain six pints. For a particular blood type, the hospital uses an
average of 12 pints per day. Due to the critical nature of a blood shortage, the
hospital wants to carry a safety stock of two days’ expected supply. How many
kanban card sets should the hospital prepare?
7. What are the implementation issues related to JIT implementation?
8. Write a note on JIT supply chain management.
12.11 Key Terms

JIT: JIT is a philosophy of scheduling wherein the entire supply channel is
synchronised to respond to the requirements of operations or customer.
Kaizen: Kaizen translated from Japanese means continuous improvement, taken
from words ‘Kai’ means continuous and ‘zen’ means improvement. It is a
management philosophy and forms the basis of the Toyota Production System
(TPS) as well as Lean Manufacturing.
Single Card Kanban System: In a single-card Kanban system, parts are produced
and bought according to a daily schedule, and deliveries to the user are controlled
by a Conveyance Kanban (called a C-Kanban).
Two-card system: The two-card system is the more popularly used Kanban
system. It uses two kinds of kanban cards: Conveyance Kanban (C-Kanban) and
Production Kanban.
Conveyance Kanban (C-kanban): It signals the need to deliver more parts to the
next work centre. It specifies the kind and quantity of product which a manufacturing
process should withdraw from a preceding process.

1. (a) Philosophy
2. (a) Holistic
3. (d) Elimination
4. (a) Layout
5. (c) Continuous
6. (a) Just in time
7. (b) Demand
8. (d) Workforce
9. (a) Kanban

10. (b) Pull
Notes 12.12 Further Readings

Gopalakrishnan P, Handbook of Materials Management, Prentice Hall of India
Narain Prahlad(2008). Inventory Management, Excel Books, New Delhi.
Reji Ismail, Logistics Management, Excel Books, Delhi.
Kachru Upendra (2007), Production and Operations Management, Excel Books,
New Delhi

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Inventory Management

For private circulation Students’ Study Material of ADDOE.

Published by: Amity Directorate of Distance & Online Education, Noida

Unit 1: Introduction to Inventory Management 01

Unit 2: Inventory Types and Functionality 15

Unit 3: Selective Inventory Control 33

Unit 4: Inventory Costs 45

Unit 5: Inventory Replenishment 61

Unit 6: Production Planning and Control 77

Unit 8: Materials Requirement Planning 104

Unit 9: Spare Parts Inventory 119

Unit 10: Stores Management 131

Unit 11: Accounting for Inventories 147

Unit 12: Just-In-Time 162

Unit 1: Introduction to Inventory Management

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In most manufacturing firms today, inventories constitute the second largest

1.2 Meaning of Inventory

1.2.2 Advantages of Holding Sizeable Inventory

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1.2.4 Components of Inventory

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1.2.5 Factors Influencing Inventory

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Amity Directorate of Distance and Online Education

1.4.1 Objectives of Inventory Management

1.4.2 Problems in Inventory Management

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1.5 Objectives of Inventory Control

1.6 Role of Inventory Manager

1.7 Inventory and Profitability

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Figure 1.1: Major items of expenditure of a typical manufacturing organisation

Labour Sales Net income

Note: All figures are in Rupees lakhs.

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Notes They have been derived thus:

Net income 950

net income net income sales

Net income 1035

net income net income sales

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1.9 Check Your Progress

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Amity Directorate of Distance and Online Education

1.11 Key Terms

Check Your Progress: Answers

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1.12 Further Readings

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Unit 2: Inventory Types and Functionality

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warehousing, working capital requirements, deterioration, insurance, taxes, and

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Amity Directorate of Distance and Online Education

2.3 Raw Materials

2.4 Work in Process Inventory

2.4.1 WIP Computation

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2.4.2 Reasons of High WIP

Notes The factors that cause high WIP are:

2.4.3 Methods to Control WIP

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